CLOs: senior holders have less to fear than sellers

There is a new bogeyman on Wall Street: collateralised loan obligation.

The rush by UK pension funds to offload assets to meet margin calls has hit the $925bn US CLO market. Leverage loan prices have fallen to as low as 92 cents on the dollar in recent weeks. The fear is stress in this part of the market could lead to a credit crunch in the wider leveraged loan market. But the angst is misplaced.

CLOs buy up risky corporate loans and repackage them into securities with varying levels of risk and return. Their structure is similar to CDOs, or collateralised debt obligations. But while mortgage-backed bonds contributed to the 2008 financial crisis, CLOs made it through largely unscathed and have grown in popularity since.

They tend to have more diversified portfolios of debt as well. Last year was a record year for US CLOs, with nearly $187bn in new issuance.  

Selling by UK pension funds may be weighing down CLO prices. Nevertheless, buyers — including Apollo, Blackstone and Carlyle — are seizing on the opportunity to pick up the most senior debt sold by CLOs at a discount. These only incur losses if the equity and subordinated tranches are completely wiped out.

Rising interest rates and a slowing global economy will put pressure on leveraged loan borrowers. Some will get their ratings downgraded. But even in the most extreme scenario modelled by S&P Global Market Intelligence, in which 60 per cent of CLO assets get downgraded and the proportion of CCC loans in a CLO portfolio jumps to 40 per cent from the current 4.5 per cent, the AAA or AA loan tranches should remain unscathed.

Supply has dwindled. Total issuance of CLOs in the US during the first nine months of this year is down 23 per cent this year at $101bn. Japan’s Norinchukin Bank, a major CLO buyer, has reportedly stopped buying.

Holders of senior tranches of CLOs probably have less to worry about than the specialist asset managers that package them for sale and the private equity funds that have come to rely on them to fund their leverage buyouts.