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Fixed income

Surviving the pandemic: A 2020 look-back on CLOs

Himani Trivedi
Head of Structured Credit
Loren Sageser
Product Specialist
Surviving the pandemic


Title card for 2021 CLO video 
Watch Himani Trivedi, Head of CLO, discuss the current market conditions, especially the credit market

In the years immediately preceding the onset of COVID, many market-watchers eyed corporate credit markets with apprehension, anticipating an eventual shake-out driven by an inevitable wave of defaults. While credit bears pointed to a number of potential catalysts for the coming shake-out – increasing leverage levels, crowded capital markets, watered-down lender protections – the collateralized loan obligation (“CLO”) market was a popular target. Many expected that CLOs would be vulnerable to an expected wave of credit downgrades, which would trigger massive selling of lower-rated credits due to breached Triple-C buckets for more detail on how rating downgrades impact a CLO see paragraph at the bottom of this page titled “CLOs 101: How do Triple-C buckets work?”

Of course, March 2020 finally saw the arrival of a default catalyst no one could have predicted, as COVID-19 led to a wave of global lockdowns which drastically curtailed business activity and created extreme pressure on corporate credit markets. As prices of corporate debt plunged and rating downgrades began to accelerate, many market watchers announced that the long-predicted armageddon for CLO investors had finally arrived. Or had it?

COVID-19’s immediate impact on CLOs

In the immediate wake of the COVID-19 pandemic, ratings agencies scrambled to assess the ramifications of the economic downturn for corporate credit. As downgrades proliferated in CLO portfolios, CCC exposures in CLOs began to expand. This led to a steady erosion in the over-collateralization levels for CLOs, and many market-watchers predicted that initial “cushion” levels would be breached, curtailing CLO equity distributions and leading to a gradual pay-down of CLO senior debt.

Exhibit 1: U.S. loan market cumulative downgrades

While CLO managers were not explicitly forced to sell lower-rated credits, the possibility of interest diversion served as a powerful motivator to re-position and de-risk portfolios. Essentially, managers were faced with three options:

1. Do "nothing": Despite a fundamentally changed economic landscape, CLO managers had the option of simply staying the course and leaving portfolios practically unchanged. While many managers adopted this course, it was a risky bet. Even though the economic snap-back was more powerful than many expected, many companies in the “COVID cross-hairs” such as restaurants and hotels were faced with starkly weakened economic prospects. While managers could choose to hold onto these credits and accept the consequences (i.e. potentially skipping distributions to CLO equity investors in favor of debt repayment), they ran the risk that these weaker credits would ultimately default and lead to permanent value destruction for CLO investors.

Exhibit 2: Month-by-month interest diversion tests during COVID (2018 vintage)

2. Reduce risk: CLO managers also had the option of de-risking portfolios by selling impaired credits and using the proceeds to purchase higher quality credits. While this approach provided a means of right-sizing CCC buckets and reducing the risk of portfolio defaults, it came at a significant price. For a CLO portfolio, selling a loan at a steep discount and re-deploying proceeds into a higher quality credit trading near par ultimately has the same effect as a default-driven loss: it permanently reduces the aggregate balance of the portfolio. This can then lead to breaches of overcollateralization tests and (potentially) interest diversion from CLO equity investors, as well as permanent losses to the CLO equity – exactly the situation that the CLO manager had originally sought to avoid.

3. Substitution trades: Another approach to re-positioning CLO portfolios involves trading out of impaired credits and into similarly priced credits with better upside potential. This sounds straightforward enough, but identifying and executing successful substitution trades during volatile markets can be extremely challenging. The onset of the coronavirus pandemic created winners and losers, with some industries benefitting and others placed at a disadvantage. However, during the early innings of the pandemic, market valuations fell almost uniformly across industries, as investors broadly de-risked. For astute CLO managers with forward-looking perspectives and robust credit underwriting capabilities, this period of time provided a window of opportunity.

Successfully re-positioning CLO portfolios during the pandemic: threading the needle

The retail sector provides a powerful example of how a well-executed and thoughtful substitution trading strategy can generate value in a CLO portfolio.

Jo-Ann Stores is a specialty retailer of crafts and fabrics. Prior to the pandemic, the company was weakened by the trade war with China; sentiment turned even more negative after the company’s retail stores were closed down at the onset of the pandemic in March 2020. In June 2020, loans issued by Jo-Ann were downgraded to CCC and began trading as low as 30 cents on the dollar.

However, the shutdown led to a resurgence of demand for stay-at-home hobbies, buoying demand for stores like Jo-Ann and Michael’s. CLO managers who correctly anticipated this shift in consumer demand were able to generate value by trading out of companies in more COVID-impaired sectors (such as movie theater chains) and switching into discounted loans of these specialty retailers.

Jo-Ann loans recently traded in the high 90s, and the company was upgraded from CCC in December. This trend impacted many companies which were downgraded during the initial phases of the pandemic but later upgraded by Standard & Poors as the trajectory of consumer demand trends became clearer.

For astute CLO managers with forward-looking perspectives and robust credit underwriting capabilities, this period of time provided a window of opportunity.

Exhibit 3: CCC-ratings upgrade activity

Active management matters – especially in CLOs

CLOs benefit from multiple layers of insulation from market volatility. While there are many rules which govern the CLO structure, none of these criteria require forced sales – an advantage which has enabled CLOs to remain resilient in the face of market swings and economic cycles over the past 25+ years.

However, the same rules which impart resiliency to CLO structures can also encourage value destruction for CLO equity investors. There are many structural “guardrails” which are designed to automatically and gradually de-risk the portfolio, safeguarding value for CLO debt investors and ensuring that CLO managers do not take on inordinate levels of risk. Highly skilled CLO managers, supported by experienced credit analysts, can successfully navigate the many rules and guardrails underpinning a CLO to generate value for both debt and equity investors in the structure.

As markets evolved in the wake of the COVID-19 pandemic, differentiation among CLO managers became more and more apparent. There was a stark difference in CLO performance, with a wide gulf between managers who successfully re-positioned portfolios and those that did not.

Exhibit 4: Over-collateralization (OC) cushions across CLO managers

As 2020 drew to a close, market doomsayers who had predicted that forced selling by CLOs would exacerbate a broader credit market meltdown were proven incorrect. CLOs remained intact, and these complex structures performed better than expected, proving how resilient CLOs are. However, while CLO portfolios generally weathered the storm, performance outcomes for CLO equity investors varied widely depending on the skill of the manager.

CLOs 101: How do Triple-C buckets work?

In order to obtain favorable ratings on CLO debt instruments, a CLO must follow a lengthy set of rules mandated by rating companies such as Moody’s and S&P. One important criteria relates to portfolio holdings of company debt rated CCC/Caa3 or lower, which are generally limited to 7.5% of the portfolio or less. If rating downgrades result in a CLO portfolio holding more than 7.5% in CCC/Caa3-rated debt, the CLO manager is forced to apply certain “haircuts” when calculating the value of the portfolio. While performing credits are generally held at par value for this calculation, CCC-rated exposure in excess of the 7.5% limit is held at the lower of market value or a punitive recovery value assumption. If this leads to a significant reduction in the calculated value of the CLO portfolio (perhaps in combination with portfolio losses due to defaults or distressed sales), the CLO may curtail distributions to equity investors in favor of debt repayment. This process (called “interest diversion) is triggered when losses and portfolio haircuts exceed the initial “cushion” levels in the CLO structure. While a CLO manager is never explicitly forced to sell any portfolio holding, CCC-driven haircuts can create a strong incentive to bring the CCC bucket back into compliance with the 7.5% threshold limit.

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