Fear has entered the leveraged loan market. Does that make it a good time for investors to buy?
As stocks reached new highs in October, there was a selloff in U.S. leveraged loans, which are the collateral supporting CLOs. Fundamentals for leveraged loans have deteriorated in recent months, as there have been growing concerns about declining earnings and rising debt loads for corporations that have utilized this market.
For background, a CLO is divided into a series of first lien, senior secured debt tranches (rated AAA, AA, A, BBB, BB and B) along with an equity class (which is unrated). The debt tranches are groups of interest-paying loans that are usually floating rate. There is also a small allowance for loans that are second lien and unsecured, including those rated CCC. The higher rated tranches are deemed to have less risk, thus getting a higher claim on cash flows and the last loss of principal. The lower rated tranches are deemed to have more risk, thus getting a lower claim on cash flows and the first loss of principal. Recently, the riskier loans that many CLOs own – rated BB or below – have experienced steep declines in price, wiping out gains for the year.
While there have been idiosyncratic issues associated with specific issuers such as McDermott International and Clover Technologies Group, most companies are still able to service their debt and defaults are expected to remain low through 2019. According to participants in the market, the dislocation in risky loans is largely driven by technical (rather than fundamental) factors.
Over the last year, outflows from loan funds have been significant. Bank loan mutual funds and ETFs have lost 35% of their assets– from $119 billion in October 2018 to $77 billion in October 2019. The outflows have been driven by investors not wanting to own leveraged loans which benefit from rising rates, now that the Fed has put future rate hikes on hold.
Over the past few years, there has been an oversupply of B-rated loans. Roughly 55% of the S&P/LSTA Leveraged Loan Index is now rated B+, B or B-. At the same time, you have less demand from mutual funds & ETFs, CLO managers, and dealers. As a result, the riskier B segment of the U.S. leveraged loan market has struggled to find a natural buyer.
Due to the structure of CLOs, managers have restrictions on how many CCC-rated leveraged loans they can hold. The majority of CLOs have a 7.5% limit on leveraged loan holdings rated CCC or below in their portfolios. Thus, managers have started reducing their B-/CCC loan exposure in anticipation of future downgrades in order to avoid failing these so-called overcollateralization (OC) tests.
All of this has led to forced selling. The loan market has been seeing an increase in “up-in-quality” trades, as CLO managers are lightening up on lower rated leveraged loans to manage their CCC buckets. For this reason, B-rated loans have been the largest detractor to index performance this year alongside CCC-rated loans.
Conversations with managers suggest the dislocation is temporary. They think there is an opportunity to identify B-/CCC loans that are oversold due to technical pressure rather than fundamentals. It will be important to select the right tranches – i.e., loans of higher credit quality. By creating a portfolio of orphaned, cheap loans, investors have the ability to capture yield and generate total return within an asset class that has historically experienced very low defaults. CLO managers argue that the B-/CCC opportunity has asymmetric upside and limited downside, with the potential for 15%+ IRRs.
However, higher-yielding loans do not come without risk. It is unclear how long the technical opportunity will last, or whether the dynamic will get even worse. Therefore, timing is key. The pace of downgrades and indiscriminate selling could accelerate from here, further pressuring lower tier loans. The last time spreads were this wide was in 2016, but we are not yet at levels reached in the first quarter of that year. Investors should be prepared for mark-to-market volatility.
Despite the recent downside pressure on CLOs, most managers believe the losses are temporary and that the CLOs will recover their losses. Their financial models show that there would need to be an extreme situation of downgrades and defaults – an “apocalyptic” scenario – in order to cause permanent capital impairment. They do not believe that this situation is likely which will allow pricing to snap back in the long run, as CLOs did after the 2008 financial crisis. Only time will tell if history repeats itself.