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Friday, July 31, 2020

Bell bottoms

“CLOs Are About to Get Easier for the Robinhood Crowd to Buy,” blares a Bloomberg headline this morning. Indeed, asset manager Janus Henderson is planning to roll out a U.S.-listed exchange traded fund focused on collateralized loan obligations (CLOs), or packaged and securitized collections of leveraged loans.  The ETF, which will be exposed to the highest quality end of the credit spectrum, would be the first such vehicle dedicated to CLOs, an asset class which has enjoyed brisk growth in tandem with the post-crisis expansion in the leveraged loan market.  

While the idea of retail investors wading into the choppy waters of securitized debt may be less than appealing to some, relative credit quality of the offering allays some concern.  “In the case of triple-A CLOs, it’s a safe and low-risk asset class,” comments David Schawel, chief investment officer at Family Management Corp.  “Yields are fairly low on triple-A CLOs in the first place, but if investors can earn 150 to 175 basis points of spread on a short duration asset, it can be attractive.” 

As Janus Henderson looks to bring the triple-A cordon of CLOs to Main Street, another yield-starved constituency has loaded up on the contraptions. Insurance industry holdings of CLO debt stood at $158 billion at year-end 2019 according to data from Barclays, up 22% from a year ago and nearly double that of 2016.  That figure represents nearly one quarter of the total market.  A June report from the National Association of Insurance Commissioners warned that under a severe recession scenario, cascading losses from CLO defaults could overwhelm the capital and surplus of four (unnamed) insurers. 

Insurers including American Equity Investment Life Insurance Co. and Apollo management’s Athene Holding Ltd. have CLO holdings of more than 75% of total adjusted capital, according to Fitch Ratings.  Credit quality is far from pristine, as the NAIC found that roughly 55% and 40%, respectively, of the pair’s CLO holdings are rated triple-B.  For context on the market’s view of the relative risk profile, triple-B-rated CLOs currently yield roughly 5% according to data from Palmer Square, more than double the 2.34% yield for the Bloomberg Barclays U.S. Aggregate Baa Index. 

That discrepancy is telling. “To say triple-B is all money good is unrealistically optimistic and puts a lot of trust in CLO managers’ ability to de-risk their weakened portfolios in a timely manner,” Jason Merrill, structured product specialist at Penn Mutual Asset Management, told Bloomberg.  “There are likely to be weaker triple-B’s that will take some amount of principal loss.” 

Pandemic and lockdown-related corporate downgrades will test the health of the CLO market.  Moody’s Investors Service reports that a record 102 U.S. nonfinancial companies are now in the “crossover zone,” meaning the boundary between investment grade and high yield.  Of the 41 companies that joined the list in the second quarter, all but three are potential “fallen angels” (investment grade credits demoted to junk),  while the ratio of fallen angels to rising stars (or those promoted to IG) now stands at 5.8:1, compared to less than 2:1 at year-end.  According to S&P’s LCD unit, the rolling three-month ratio of downgrades to upgrades in June for the underlying leveraged loans stood at 18.4-to-1, more than double the financial crisis-era peak.

That raft of downgrades is causing a pile-up at the lower credit reaches, as analysts from Barclays forecast that the ratio of triple-C-rated loans will approach 12% by year-end.  That is potentially significant as CLO managers are typically limited to a 7.5% portfolio cap on triple-C-rated issues. Exceeding that threshold, a manager would need either to sell quickly out of those positions or face restrictions on investor payouts and unfavorable mark-to-market rules on the excess triple-C-rated assets.

Of course, further fundamental deterioration from triple-C credits can often spell default.  With covenant protections largely hollowed out over this cycle, managers and investors could be in for a surprise.  “CLO ratings and the risk of a loss on CLO tranches rely on the loss assumptions of the underlying risky leveraged loans,” writes UBS credit strategist Stephen Caprio, referring to historical loan recovery rates of 70 to 80 cents on the dollar. “Recovery rates [in this cycle] are already problematic. What should be crystal clear is that leveraged loan recovery rates are going to be lower than historical levels.”  

Recap July 31

Disappointment averted, as a late rally pushed the S&P 500 higher by nearly 1% at the close after sluggish trading for most of the day followed strong results from a quartet of tech giants overnight. Treasurys enjoyed yet another green showing with the 5-year yield falling to 0.21%, well below the 0.25% top end of the range for the Fed’s overnight Funds rate.  Gold broke to another fresh high of $1,972 an ounce, WTI crude held near $40.5 a barrel, and the VIX closed below 24 for the first time since Feb. 21.  

- Philip Grant