An unprecedented amount of leveraged loan downgrades could wreak havoc on collateralized loan obligations. Take the once high-flying Cirque Du Soleil Inc. Within weeks of the acrobatic-entertainment company canceling Las Vegas and touring shows, Moody’s Investors Service and S&P Global Ratings slashed ratings on about $1 billion of the company’s debt, the majority of which is held by CLOs, according to data compiled by Bloomberg.
While an individual loan downgrade likely wouldn’t damage a CLO’s ability to pay investors, a deluge of them around the same time certainly could. S&P has cut or put on negative watch at least $45 billion of the average portfolio of leveraged loans in CLOs since late February amid the fallout from the coronavirus which has shuttered businesses, according to a recent report by Bank of America Corp. Loans CLO Pain Just Starting With Leveraged loan Rating Cuts
CLO bonds downgraded
The pile of downgrades could leave portfolio managers two unpleasant options: Dump lower-rated loans at fire-sale prices or cut interest payments to some of their investors and face having CLO bonds downgraded themselves.For the $670 billion CLO market, the fall of Cirque Du Soleil and other companies highlights how quickly the long-feared specter of a barrage of downgrades is materializing.
The worry has expanded beyond loans rated B3 by Moody’s, those on the cusp of the lowest CCC tier, because credit graders are axing some issuers by multiple notches.
Moody’s cut Cirque Du Soleil by four notches to Ca from B3 while S&P downgraded by three notches to CCC- from B-.CCC BucketsAt the heart of concerns is a key CLO feature that limits the amount of CCC rated loans that most can hold to 7.5%. Already 30% of CLOs likely exceed that maximum capacity, a sharp rise from about 8% earlier in the year, according to the Bank of America report published last week.
That figure is likely to worsen, given the current pace of downgrades, and more so if efforts to contain the spread of the coronavirus push the economy into a recession as some Wall Street economists predict. These securitized vehicles operate under strict ratings-based criteria and tests that are designed to protect the investors of the bonds — but those constraints can also have painful consequences for those that hold the equity or lower-rated tranches. Loans CLO Pain Just Starting With Leveraged loan Rating Cuts
Ratings firms have been very aggressive with multiple notch downgrades and negative watches, so the CCC baskets are overflowing, said one US CLO manager, who notes how tough it is to trade through all this. If this keeps up, lots of CLO tranches may be downgraded and equity cash flows in some deals will be reduced or shut off, the manager said.Adding to worries, leveraged loan prices may be set to fall. The S&P/LSTA leveraged loan index has recovered back to the 80s, but Barclays Plc expects leveraged loan prices go as low as 67 cents, close to financial crisis nadirs of 2008.
“It’s very difficult for CLO managers to exit out of the positions unless they realize a large loss,” said Pratik Gupta, a research analyst at Bank of America in an interview. “If the portfolio quality continues to deteriorate at this pace, there is a high possibility that some BBB bonds will get downgraded.”
Signs of downgrade stress are already apparent. Lower-tier CLO bonds, those rated investment-grade BBB and non-investment grade BB tranches, have seen yields blow out and prices tumble. BBBs are quoted as low as 60 cents on the dollar and BBs are quoted as low as 40 cents on the dollar, according to people familiar with the matter who aren’t authorized to speak publicly.
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