Anticipating the economic fallout stemming from the coronavirus pandemic, the Federal Reserve (Fed) deployed its Term Asset-Backed Securities Loan Facility (TALF), which it initially established in 2008 to shore up asset-backed securities markets during the 2008 global financial crisis (GFC). After excluding CLOs from the program’s initial scope in March 2020, the Fed announced the following month that, in addition to other structured products, certain AAA-rated collateralized loan obligations (CLOs) would be included in the program.
CLOs are an important element of credit markets, accounting for about $700 billion of the $1.2 trillion in outstanding leveraged loans, or loans made to companies with below investment grade credit.1 CLOs help ensure that rising debt levels do not lead to a credit crisis (similar to the GFC following the collapse in the mortgage markets) by providing credit to riskier borrowers while insulating the banking system from outsized exposure to risky loans. As Federal Reserve Chairman Jerome Powell noted in 2018, “elevated business bankruptcies and outsized losses…are unlikely to pose a threat to the safety and soundness of the institutions at the core of the system and, instead, are likely to fall on investors in vehicles like collateralized loan obligations with stable funding that present little threat of damaging fire sales.”2 The Fed’s confidence in the stability of institutions, however, does not mean that the sector is systemically unimportant. Moreover, this view provides little comfort to CLO investors who ultimately may bear the costs of the coronavirus pandemic.
The leveraged loans underlying CLOs are typically first liens on assets and, therefore, tend to be senior to other debt that the company may have. Like other structured products, CLO cash flows to the certificates are dictated by the performance of pools of underlying loan collateral, with senior tranches receiving priority over mezzanine and equity tranches. Senior tranches also benefit from credit enhancements, such as overcollateralization (OC) and excess spreads, which provide additional security against cash shortfalls. It is these structural aspects of CLOs that allow senior tranches to secure higher (e.g., AAA) ratings.
While CLO waterfall structures tend to share similar features with the residential mortgage backed securities (RMBS) at the center of the GFC, there are important distinctions. CLO structures are less complex than the structured products that led to the mortgage crisis and are not the target of resecuritizations, such as collateralized debt obligation (CDO) and CDO-squared deals, which proliferated before the GFC. CLOs also have a 2 to 5 year reinvestment period, during which the manager is able buy and sell underlying loans in order to improve the quality of the portfolio, mitigate losses, or enhance returns. After the reinvestment period, the CLO collateral pool is fixed, such that cash flows are then used to pay the outstanding CLO notes, which typically bear floating (rather than fixed) interest rates. A typical CLO lifecycle is about 8 to 10 years.
Historically, CLOs have proven to be relatively safe investment vehicles, having weathered the GFC largely unscathed. No AAA rated CLO certificate has ever defaulted and only 38 of more than 10,000 CLO tranches rates by S&P have experienced a default.3 Since the GFC, however, the leveraged loan market has become dominated by “covenant lite” loans, which now represent the majority of the leveraged loan market.4 Thus, recourse on the loans underlying CLOs may be limited if borrowers default following business disruptions brought on by the pandemic and economic contraction. As the saying goes, past performance may not be indicative of future results, especially for holders of junior CLO tranches.
As was the case in RMBS markets in the GFC, credit enhancements may take center stage for mezzanine and equity tranches as the fallout from the coronavirus unfolds. April 2020 saw ratings agencies put more than 1,000 tranches on review for downgrades along with the first CLO to fail a senior overcollateralization test since 2008.5 As ratings agencies continue to downgrade underlying collateral, some CLO managers may be able to improve collateral by trading for more highly rated loans; however, with the recent trend toward shorter reinvestment periods, not all CLO managers would have this strategy available. CLOs with high exposure to industries affected by the recent economic slowdown could face challenges to the extent underlying loans experience widespread and significant downgrades.
If increasing numbers of CLOs fail overcollateralization tests and redirect cash flows to more senior tranches, the value of junior tranches could become increasingly uncertain. Unlike high yield bonds, whose cash flow streams remain tethered to a single company’s capital structure, cash flows to CLO tranches can change dramatically after a triggering event. At that stage, the risk profile of the cash flows remaining to service junior tranches can vary dramatically from one CLO to the next, as risk elements of the underlying collateral (such as the stringency with which underwriting criteria were applied) come into play and may determine the timing and certainty of cash flows.
All of this presents challenges for assessing the value of junior CLO holdings, as the economic, financial, and structural assumptions underlying valuations could leave significant room for judgment. These challenges are only amplified by current financial market volatility, especially given that the settlement of CLO transactions may take weeks or longer, during which time economic conditions can change dramatically. Such uncertainty suppresses the value of junior tranches and forces investors to rethink required returns before taking a position.
While it may be tempting to view junior CLO certificates as a small sector that is of relatively little systematic significance, it is important to bear in mind that without the junior certificates, the senior certificates—and the entire issuance—cannot proceed. Thus, uncertainty surrounding junior certificates could “lock up” the entire CLO market and cause lending to come to a halt, similar to what happened in the GFC. Indeed, CLO originations are down significantly since the pandemic began, with U.S. issuances down by nearly half in the first quarter of 2020 compared to the first quarter of Q1 2019.6
Regardless of the Fed’s commitment to support senior CLO tranches, markets for the entire CLO structure must exist for leveraged loans to start moving from warehouses to credit markets. If TALF and other programs do not address uncertainty surrounding junior certificates, government intervention may not achieve its objective.
3Id.; Rennison, J., “Coronavirus sell-off puts faith in CLOs to the test,” The Financial Times,” 4/23/20, retrieved from http://www.ft.com.
4Vandevelde, M., “Why ‘covenant lite’ loans are not the menace they seem,” The Financial Times, 2/15/19, retrieved from http://www.ft.com.
5Rennison, J., “Rating agencies put 1,000 CLO slices on review for downgrade,” The Financial Times, 4/23/20, retrieved from http://www.ft.com; https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/for-1st-time-since-2008-a-clo-triggers-its-senior-overcollateralization-test-58047116.