One month ago, we noticed the latest "shoe to drop" in the global credit rout, when as a result of soaring downgrades to energy companies' credit ratings, the Collateralized Loan Obligations (CLO) market went into a state of frozen animation, leading to a standstill in new CLO issuance.
As we previously wrote citing S&P, the credit quality of CLO assets is deteriorating, the result of 45 energy borrower downgrades in February. S&P said that the credit ratings of around 1.4% of assets held by US CLOs have been downgraded or placed on credit watch with negative implications this year. Worse, the sudden repricing means that the negative total returns of US CLO BBs and single-Bs in January have already been more severe than those realized in the entire year of 2015.
As Chris Flanagan, head of US mortgage and structured finance research at Bank of America Merrill Lynch in New York, said "people are definitely trying to get their heads around what [increased CCC holdings] says about the credit cycle. The market has changed dramatically in just six weeks.”
We noted that the biggest implication from the ongoing rout to the CLO 2.0 product is that the lower issuance of CLOs, the main buyers of leveraged loans, will make it harder for companies to issue new debt in the already-challenged US$870bn US leveraged loan market which provides junk loans to companies including retailer Dollar Tree and countless near-distress shale companies.
Indeed, we have already seen the flipside of this when as reported previously, the vast majority of "use of proceeds" from energy equity offerings has been to repay secured debt and energy revolvers.
As a way of keeping tabs on the not so quiet selling in the CLO space, we noted that as of the end of January, the median CLO 2.0 equity NAVs tumbled by 9 percentage points, or by 85%, and according to Morgan Stanley calculations, a whopping 348 US CLO 2.0 deals’ equity tranches had NAV below zero as shown in the chart below.
Since then, as we expected, the CLO rout has gone from bad to worse, and according to the latest Morgan Stanley CLO tracker, as of the end of February, the median US CLO 2.0 equity NAV stood at -1.99 with the number of CLO 2.0 deals’ equity tranches currently having NAV below zero soaring by 30% from 348 to 453.
Over the same period, the underlying asset deterioration continued and on February 29, the median CCC assets in US CLO portfolios continued to increase in February, to 4.30% from 3.90% in January.
What is more troubling, however, and what may explain the ECB's scramble to unleash a corporate bond QE is that while Europe had been isolated from the U.S. contagion in January, in February things flipped with the bulk of the pain hitting European CLO assets. More details from MS: "Lower loan prices in Europe has impacted European CLO equity land meaningfully, as median equity NAV declined nearly 11 points to 54.1 from 64.8 last month, or by 16.5%."
Remember that unlike the US, the bulk of corporate funding in Europe is in the form of bank loans, so a complete shutdown of the European CLO market would have more pronounced consequences on funding pathways than in the U.S., where corporate bond issuance remains the preferred method of issuing debt.
So was Draghi looking at the chart above when deciding how to expand Europe's QE (and yes, Draghi's son Giacomo is employed at Morgan Stanley)? We'll never know.
In any case, the question everyone is asking is whether the ECB's expansion into private asset purchases will lead to the unlocking of the CLO market.
Here are some thoughts from Morgan Stanley which is not optimistic on the prospects, and in fact, has just lowered its 2016 issuance forecast from $60 billion in the "base case" to just $45 billion, suggesting secured loan funding will remain a troublesome spot for companies, mostly energy, in need of secured debt.
Putting the ongoing deterioration in context:
Leveraged Loan Markets Remain Stressed: CLO portfolios continue to have higher average Sharpe ratios than most components of the loan index, since overall, the loan market is relatively more distressed. While it could be argued that certain CLO portfolios’ liquidity is lower than large, flow loan names in the LL100 Index, and therefore not as sensitive to marked-to-market changes, we noted in A Premium for Liquidity Part II: Leverage Loans that higher Sharpe ratios are not necessarily associated with higher weighted average liquidity scores (weaker liquidity portfolios) across CLO 2.0 deals.
Median CLO Portfolio Prices Notably Lower and Volatility Remained Elevated in 2015: Median standard deviation (annualized, LTM) of CLO portfolio total returns, or the ‘volatility’, increased to 1.40% as of February 29 from 1.34%, as of January 31. Median CLO 2.0 average portfolio prices continue to slide lower, falling to 91.8 at the end of February from 92.4 at the end of January.
The max pain in the CLO space remains driven by oil and gas loans:
- Among the 180 loan issuers with price drops larger than 5 points in February 2016, we see 32 issuers in Oil & Gas, 24 in Computers and Electronics, 15 in Healthcare, 12 in Professional & Business Services, 9 in Chemicals, 8 in Healthcare, and 7 in Metals and Mining.
- Many of the names with large price declines have appeared more than once in our loan price drop alert. In February 2016, the average maximum price drop for loans on these issuers stands at 9.11 points.
- 851 CLO transactions have exposure to these 180 issuers, with a median exposure across all CLOs of 7.07%, a median exposure of 6.19% in the CLO 1.0 space across 197 deals and a median exposure of 7.07% in the CLO 2.0 space across 654 deals.
As would be expected, liquidity continues to deteriorate:
Liquidity Declines for US CLO Deals: The median weighted average liquidity score for US deals has continued to increase for the fifth consecutive month to 2.60 in February from 2.58 last month. In fact, liquidity scores are at their highest points since January 2015, given market volatility and sector-specific distress have been rising. This is indicative of a meaningful drop in collateral liquidity throughout 2015 and to start the year in 2016.
The above disturbing trends lead MS to reduce its forecast for 2016 full year issuance to an even more paltry number:
Why Do We Lower Our Issuance Forecast as US Corp Credit Rallies?
The tone in US CLO new issuance discussion seemed bearish at the Las Vegas conference, and we think the perception is likely the reality. Despite the strong rally in the broader credit market starting in the last week of February, the primary US CLO market is unlikely to be the major beneficiary, in our view.
- First, we think the US credit cycle has likely turned already, or at the minimum it is at its late phase. A bear market rally could happen, but issuance volumes are typically lower in the late stage of the cycle, for both loans and CLOs as lending conditions tighten and investors turn risk averse.
- Second, defaults are likely to increase despite the recent rally in HY and loans. We still find a significant portion of the loan market priced at distressed levels, and the overall rating migration of the loan universe is still downgrade biased, as suggested by Moody’s forecast. In this type of environment, we expect third party (non-manager) interest in CLO equity tranches to be limited, which further reduces the number of managers who could bring new deals to the market this year.
- In addition, we think valuations are cheaper in the CLO secondary market. Investors’ general feedback from the Las Vegas ABS conference was more constructive on secondary CLOs as valuations are more dislocated. The demand for new issue paper will likely give way to that for secondary paper.
We believe these headwinds are likely to remain for most of 2016. We published our “bull/base/bear” forecasts in our 2016 Outlook in December 2015, in which we projected less than $50bln of 2016 US issuance as the “bear case”, and $60bln as the “base case”. Since then, the CLO space has migrated toward the “bear case” scenario, with the new issue machine losing steam in both the US and Europe, and spreads in both the primary and secondary markets widening considerably. Effectively, the then “bear case” becomes the new “base case”. In this context, we reduce our 2016 US CLO issuance forecast to $40-45bln.
We also reduce our EUR CLO issuance forecast to €10bln as the contagion effect from weakness in the broader credit is likely to reduce demand for the asset class, part of which has been reflected in the sluggish YTD issuance in Europe.
Not surprising in this sudden freeze of new issuance is that according to MS, USD-denominated loan issuers continued to push out their maturities, with approximately 12.2% of loans now maturing between 2016 and 2018, 14.1% of loans now maturing in 2019, and 73.8% now maturing on or beyond 2020.
Finally, while it was the lowest rated paper, namely that rated B, which was smashed in January, in February it was the highest tranches that were hit the most, together with some notable weakness in BBB- rated CMBS.
Also, as noted above, from a total return perspective, European CLOs significantly underperformed comparably rated corporate bonds, leveraged loans and US CLOs. US CLO BBs (median total return at negative 3.54%) and single-As (median total return at negative 3.32%) underperformed within the capital structure, as well as compared to the broader US credit market. US single-B CLOs tranches have seen a wide range of total return performance with the standard deviation of total returns at 11.56% and the median total return at 0.99%, depending on the credit quality of the bond profile.
It's all in Draghi's hands now.