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US loan investors braced for jump in defaults.

 The biggest buyers of US junk loans are expected to shrink their exposure to the $1.4tn market in 2023 as the Federal Reserve’s campaign of interest rate rises sparks rating downgrades and defaults. CLOs, which package such loans into various risk categories before selling the slices to investors, has performed well during tough economic times. Still, analysts say mechanisms designed to protect investors holding higher-quality tranches could reduce the vehicles’ appetite for loans to risky, highly indebted borrowers. For example, US CLO issuance ballooned during the pandemic, reaching an unprecedented $183bn in 2021 as near-zero borrowing costs sparked a broader explosion of capital market activity. When these protective switches are tripped, cash flows to investors holding the riskiest CLO tranches, known as «equity», can sometimes be cut off, redirecting payments to investors higher up the pecking order.



«Leveraged loans, the underlying collateral in CLOs, are expected to face increased stress as interest costs are rising and earnings are likely to drop simultaneously,» analysts at Barclays wrote in December. «We’re not talking about breaching the 7.5 per cent threshold by just a little bit,» said Steve Caprio, head of European and US credit strategy at Deutsche Bank Research. «We’re talking about CCCs potentially going as high as 12 to 15 per cent in the worst-case scenario». Analysts at Bank of America expect triple C buckets to increase to «8-10 per cent in a stress and potentially even 15 per cent in a severe stress scenario», noting that the peak Covid triple C concentration in CLOs was 10 per cent.

Swiss bank UBS also said, «a surge in leveraged loan credit deterioration should increase holdings in CLOs to 15 per cent, drying up demand from CLOs». Caprio added that it would be «difficult to entice a new investor» to wade into the lowlier-rated CLO tranches when the risk of having regular payments turned off is «actually quite elevated». CLOs’ risk exposure varies, and many managers have built up protection against overflowing low-grade debt buckets. Barclays said that the share of triple C-rated loans in CLO portfolios has fallen to about 4 per cent.

«There’s a lot of cushions before it is a problematic dynamic for CLOs,» said Jeff Stroll, chief investment officer at Post Advisory Group. Concerns about overflows of low-quality loans in CLOs were «probably more valid for pre-Covid and especially vintages from the 2016 commodity crisis», said Rishad Ahluwalia at JPMorgan. «The ratios in the last two to three years of CLOs are much lower than the average». Ahluwalia said CLOs are now also buying fewer loans from the rating category just above triple C out of concerns that if they are downgraded, they will move down a notch and count against the threshold.

Anticipating «very, very elevated» downgrade rates for B and B minus rated loans into triple C buckets, Caprio concurred that CLO managers «will probably try to avert the problem» of breaching 7.5 per cent thresholds by reducing their demand for loans ranked just above this level. But «that in and of itself, before the problem emerges, will cause some issues within the loan market». Even at the top of CLOs’ capital structures, demand has weakened. The US big banks have pulled back» from the top triple-A tranches of CLO debt this year;

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Comments

  1. Jim4 January 2023 at 13:03

    This happened in 2008 if I remember correctly. So we are probably in for a very difficult period.

    ReplyDelete
    Replies
    1. Robert4 January 2023 at 13:59

      Yes, we are in for some serious turbulence. Everything is pointing in that direction.

      Delete
    2. Eric4 January 2023 at 19:25

      The problems we had in 2008 might look like a picnic compared to what’s to come. I hope this isn’t true but it sure looks and feels like it.

      Delete

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