In brief…
With the world in lockdown, companies struggling
to service their debt and the knock-on effects on the
labour market, the prospects of company defaults loom
large. Laura Ashley and Carphone Warehouse have
been early victims of the economic crisis caused by
COVID-19 and sectors such as aviation, gaming, lodging
and leisure are feeling the pressure together with the
oil and gas sector which is suffering from the freefall in
oil prices. Despite the economic measures previously
announced by a variety of governments and regulators,
including a GBP350 billion package announced by
the UK government and the Bank of England slashing
interest rates from 0.75% to 0.25% and then further to
0.1%, collateral managers continue to grapple with the
current credit environment.
Initially as credit conditions began to deteriorate,
investors in European CLOs who were looking to sell
CLO liabilities found it difficult to find buyers with a
number of bids-wanted-in-competition (BWICs) failing
to result in sales. This was due to, amongst other
things, concerns around the market value coverage of
junior CLO tranches and the fact that there were less
traders in the market to create the required liquidity
as they increasingly opted to work from home to avoid
infection.1 However, more recently the secondary market
looks to have improved as the number of successful
European BWICs has begun to rise albeit with less triple
A rated bonds being sold following the establishment
by the US Federal Reserve Board of the primary dealer credit facility.2
With this backdrop in mind, there are a number
of challenges and opportunities for European
CLO managers tasked with navigating this
tumultuous environment.
- With the current deterioration in the business
environment and the associated increase in business
risks, certain CLO assets are likely to decline in credit
quality and/or price or the underlying obligors
may fail to meet their other financial obligations.
In these circumstances a collateral manager may
(depending on the where the relevant CLO is in terms
of reinvestment period or if it is in a restricted trading
period) have the discretion to determine that such
assets constitute “credit risk” assets and look to sell to
mitigate losses.
- There is a risk of the ratings of certain CLO assets
falling to CCC+ (or lower) levels and thereby
increasing the number of CCC rated CLO assets to
above the permitted limits. The resultant excess
of CCC rated CLO assets will be subject to haircuts
in the determination of certain par value and
overcollateralisation tests and the restrictions set out
in the relevant portfolio profile tests and to the extent
this causes such tests to fail, can push a CLO toward
early amortisation and cause a reduction in the
amounts available for distribution. Collateral managers
will be keen to keep the CCC rated CLO assets within
the approved limits. This is easier said than done,
with recent reports suggesting that the number of
CLOs breaching their permitted limits for CCC rated
CLO assets (typically 7.5 percent.) set to soar from
8 percent. to around 30 percent.3 with CCC rated
CLO assets in CLO portfolios having increased on
average by 2 percent since February 2020.4
- Corporate defaults may lead to CLO assets being
classed as defaulted assets. Depending on the size
of the relevant defaulted position held by the CLO,
collateral managers may find themselves involved
in workouts or restructurings, these can result in
changes to interest rates, write-downs of principal,
conversion of some or all of the principal debt
into equity and generally to the terms, conditions
and covenants of the relevant defaulted asset.
Such workouts or restructurings can be protracted
and the ultimate recoveries uncertain. Unsurprisingly
defaulted assets typically have limited liquidity and
in the event that they are actually sold they will
typically be sold at a discount or loss. Defaulted
assets held in a CLO will be subject to haircuts
and/or excluded in the determination of certain
par value, interest coverage and overcollateralization
tests, and like CCC rated CLO assets, failure of these
tests, can push a CLO toward early amortisation
and cause a reduction in the amounts available for
distribution ultimately, if not addressed, defaulted
assets can contribute to a CLO default.
- Another feature of European CLOs that could
potentially exacerbate the situation are covenant
light loans in portfolios, these are loans that do not
contain any financial covenants or require the obligor
to comply with any maintenance covenants. In the
current economic climate, these reduced covenant
packages mean that companies which should have
defaulted earlier are actually carrying on so that when
they do eventually default the recoveries will in many
cases be lower.
Clearly there are a number of challenges for collateral
managers in the current climate but for those
collateral managers that have cash to deploy and
are still able to purchase assets at a discount there
could be opportunities to pick up bargains and build
par. These discount assets can have less favourable
treatment in a CLO initially but under certain
circumstances can be treated as regular assets or in the
case of so called swapped non-discount assets, collateral
managers, under certain conditions, have the ability
to purchase assets at a discount without treating such
assets as discount assets from the outset.
It is still early days in the current corona virus
environment with little certainty on how long these
conditions may last and when a medical and an
economic recovery might begin and what the post
-corona virus economic landscape might look like.
In the meantime collateral managers will have to face
deteriorating credit conditions, questionable liquidity,
potential work outs and restructurings while European
CLO investors rely on them to maximise prices
and recoveries.
Although collateral managers have the unenviable
task of weathering this particular storm, it is
worth remembering that CLOs are designed with
structural protections in order to deal with these
disruptions in performance. These features include
overcollateralisation, diversification, subordination,
the ability to defer interest payments and in some
cases the ability to reserve funds. These features,
many of which are agreed with and monitored by the
relevant rating agencies, have served the CLO industry
well and seen it survive and thrive through a number
of economic downturns and recessions so there is
every reason to believe that European CLOs are robust
enough to weather this current environment.
1 Global Capital 16 March 2020 – Investors caught in the headlights as ABS and CLO lurch wider
2 See Creditflux 30 March 2020
3 According to the latest research from Bank of America – See Creditflux 26 March 2020
4 See Creditflux 26 March 2020