Andrii Dodonov
By Jared Feeney, CFA
While downgrades of loans to CCC could accelerate, we believe high-quality CLOs are well-positioned to absorb the additional CCC exposure.
With macro fundamentals deteriorating and the probability of a global recession increasing, the Collateralized Loan Obligation (CLO) market is focused on accelerating loan downgrades to CCC, particularly given the significant increase in B- rated credits within CLOs since early 2020 (the share of B- rated collateral is up from 20% in 2020 to 28% today). While median CCC exposures in CLOs quickly increased to approximately 10% during the COVID-19 pandemic as rating agencies took a proactive approach to downgrades, our view is that this cycle could be more protracted.
As a result, we expect the CLO market to be better positioned to absorb downgrades, with an active management approach allowing managers to proactively trade out of CCC candidates over a longer cycle, which may dampen the magnitude of the increase in CCCs in portfolios versus what was experienced in 2020. From a CLO debt-trading standpoint, we believe the expectation of higher CCCs is at least partially captured in current CLO debt spread levels, with a third of B- credits in the loan index trading below 90, implying future downgrades to CCC. In addition, if elevated CCC loan exposure leads to overcollateralization test-breaches in a CLO, cash flow within the CLO would be redirected to repay senior CLO debt, deleveraging the CLO—a credit-accretive outcome for CLO debt investors.
Regarding opportunities in CLO debt, while CLO BBs have outperformed high yield year-to-date on a total return basis, this has been driven by rate duration as opposed to credit-spread widening. Further, CLO BB spreads are historically wide versus BB high yield, with the current spread basis at around 700 basis points, versus the historical average of 300 – 400 basis points. Taking into consideration this spread basis, we believe CLO BB debt is attractive today.
Despite macro and loan downgrade concerns, we continue to be confident in the significant structural protection provided against credit losses in underlying loan portfolios. In our view, this structural support, combined with an investor focus on having a deep understanding of the underlying collateral, is paramount in analyzing and stress-testing CLO portfolios. CLO structures in general, and CLO BBs in particular, have showed themselves once again to be robust in the face of 2020’s significant recession. In our view, CLO BBs backed by high-quality loan portfolios have the potential to generate outperformance versus peer asset classes over the current credit cycle.
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