Despite the late-cycle environment, we believe the recent negative headlines on CLOs are somewhat overstated, and do little justice to the many benefits of the asset class—which has delivered impressive risk-adjusted returns and low defaults over time.
The fact that today’s collateralized loan obligation (CLO) market has often found itself in the crosshairs of the financial press—purportedly mired in ‘hidden risks’—suggests that the asset class tends to be somewhat misunderstood, and the benefits overlooked.
It’s important to acknowledge that we are, in fact, deep in the throes of an elongated credit cycle, and market jitters are not only commonplace, but in many cases, substantiated. That said, there is a danger that fear around CLOs—potentially stoked by negative headlines and rooted in a misunderstanding of their mechanics—could result in a missed opportunity for investors to earn potentially strong risk-adjusted returns in what has proven time and time again to be a resilient asset class.
In recent months, we’ve seen two predominant concerns highlighted in the press: widespread stress in the leveraged loan market, and looser documentation—both within CLOs and the underlying loans by which they are collateralized.
Concern #1: Underlying Loan Market Stress
Late-cycle credit market fears are nothing new to investors, especially with a current cycle that is now more than 10 years in the making. But fears intensified last year, as evidenced by outflows from the leveraged loan market (likely also heavily driven by lower interest rates), a number of idiosyncratic credits that encountered stress, and the underperformance—though still positive returns—of loans versus high yield bonds.
Within CLOs specifically, the primary concern is that the loan market weakness will lead to a spate of downgrades from single-B rated loans to CCC rated loans in their underlying collateral. This has the potential to rattle CLO investors for two reasons:
- First, if there’s a greater percentage of CCCs within the collateral pool, inching nearer and nearer to its typical 7.5% threshold—investors could potentially be exposed to credit losses and/or defaults within the CCC bucket. And if that bucket continues to grow, it could eventually trigger the structure’s cash diversion mechanism and cut off cash flows to the junior debt tranches.
- Second, in order to prevent that, CLO managers might decide to sell those newly-downgraded CCC assets into the market at unfavorable prices.
While these are valid concerns, there is more nuance than may be obvious at the headline level. For the leveraged loan market, despite broader late-cycle concerns, interest coverage ratios and balance sheets are still quite strong. Loans are secured by the assets of the company, and have demonstrated historically strong performance with lower volatility. Maturities have been pushed out—which means we do not face a ‘maturity wall’ over the next few years, in which a substantial portion of the loan market would need immediate financing at the same time. There are also typically solid equity cushions beneath the debt, and defaults are still low, and expected to remain that way for the near to medium term.