CLO Credit, Collateral Conditions To Worsen In 2023

By Miles Li & Luke Lu, Yield Book Research

The collateralized loan obligations (CLO) market seems likely to face a further deterioration in the credit and collateral environment in 2023 amid high inflation, higher interest rates, and the looming threat of a global recession.

As borrower debt-service capacity is further pressured by these macroeconomic headwinds and corporate profit margins squeezed, the credit fundamental deterioration may intensify in 2023, driven by sectors such as consumer goods, retail, chemicals, and real estate.

Tightening credit fundamentals

Financing conditions are expected to remain tight and volatile in much of 2023, with some sectors “vulnerable” to increased default risk because of the difficulty in passing on the rising cost to customers.

Although a few sectors including commodities, energy, and banks, may be able to weather the downturn slightly better, while other borrowers are well positioned entering next year with sufficient capital buffer, market stress and recession may push speculative-grade corporate default rates to more than double next year.

In 2023, the leveraged loan default rate is expected to reach 5% (compared with a pandemic peak rate of 4.5%) and CLO asset default rate to hit 2%.

Ratings downgrade risk concerns rise

The CCC downgrades coupled with the rapid increase in B3/B- rated CLO exposure is a growing concern in the market.

The current CCC% is around 3.5%, barely above the lowest level in the past three years but may rise to a high single digit next year, or even approach the pandemic high of 11% because of reduced access to capital.

For the B3/B- rated CLOs, many of these issuers could face difficulty covering their interest expenses and refinancing upon maturity, leading to increased downgrade risk.

An increase in downgrades and defaults may lead to par haircuts and cause some over-collateralisation (OC) triggers to breach.

However, the risk is mitigated by robust OC cushions, the way CLOs are structured with a cap of 7.5% cap on CCC-rated assets in their deal indentures, and active management by CLO managers. According to Yield Book’s November report, there will only be 6.05% of CLOs failing junior OC tests under an assumption of 10% CCC and a 2% constant default rate (CDR).

New issuances extend decline

Investor demand looks likely to remain weak in 2023 following a pullback in CLO purchases in 2022, particularly by US banks on the back of increased capital requirements and Japanese AAA investors, which resulted in CLO AAA underperformance vs. loans (and hence a shrunk equity arbitrage).

New issuance volume in 2023 is expected to decline modestly (5-10%) in a base case scenario, from 2022. A further downturn could result in 20-30% lower volumes, whereas a bullish environment could result in volumes increasing by 5-10%, Yield Book analysis shows.

But while refinancing and reset activity dried up in 2022, there could be an uptick next year of $30-40bn (vs. $22bn YTD). Around 23% of CLOs will exit the reinvestment period next year and begin to amortize or look to reset/extend, leading to potentially more reset issuance.

In addition, if spreads tighten amid improving conditions, refinancings could occur among 2022 transactions with short (one-year) non-call periods.

Turbulence ahead for CLO managers

CLO managers delivered a solid performance in 2022 despite treacherous market conditions. On the collateral quality side, the CCC percentage has been declining since late 2020 because of risk mitigation efforts but the default rate this year has been contained at a level far below the leveraged loan market average (1.5%), and around half of the pandemic level (4.5%).

Furthermore, on the deal structural side, the average junior OC cushions in 2022 exceeded 2020 and 2021 levels even after the recent downgrading waves, providing strong structural protection to the liabilities.

For equity holders, despite the rising liability costs, diminished index floor benefit, and steepened 3s1s curve, managers still delivered an average quarterly equity distribution of ~3%. Furthermore, managers took advantage of the price dislocation and found opportunities to build additional par (e.g., rotating into higher-rated high-yield bonds from CCC loans at similar price levels), maintaining a positive par build number throughout the year.

Even though CLO managers navigated a challenging environment, they are set to face turbulence next year.

Many smaller managers who issued deals between 2018-2021 failed to print any transactions in 2022. And a lot of managers will face a significant number of deals exiting reinvestment period in 2023. Meanwhile, the compressed equity profit margin will continue to challenge CLO managers, which could result in more CLO manager consolidation activity in 2023.

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