C&B Notes

Is Enhanced the Right Word?

Our past notes about the growth in ‘covenant-lite’ loans appear almost quaint in retrospect.  In today’s U.S. leveraged loan market, which has doubled over the past decade to almost $1.2 trillion, 80% of all loans have these cov-lite structures.  Market participants continue to package these loans into further-levered CLOs, with a new batch of CLOs going one step further.  These issuances are increasing the amount of triple-C rated loans they can hold.  They are being called…wait for it…”enhanced” CLOs. Now that is bold.

Since November of last year, three different money managers have issued $1.6 billion of so-called enhanced collateralized loan obligations that are set up to hold a much larger amount of loans with extremely low credit ratings than typical CLOs. At least two more managers are expected to follow suit in the coming months.  The emergence of the enhanced CLOs underscores investors’ growing belief the U.S. economy is due for a recession after more than a decade of expansion. It also reflects particular concerns about corporate loans, starting with a decline in their average credit ratings. Since 2011, the amount of loans rated B or B-minus—just above near-rock bottom triple-C ratings—have ballooned to 39% of the market from 17%, according to LCD, a unit of S&P Global Market Intelligence.

As a result, some investors worry that even a modest economic slowdown could lead to a rash of loans being downgraded to triple-C. That could force selling from standard CLOs, which are designed to fill only 7.5% of their portfolios with triple-C rated loans. But it could also create opportunities for the new CLOs to buy the downgraded loans at steep discounts because they can stock up to half their portfolios with triple-C debt…

At their essence, CLOs are leveraged investment funds. A typical CLO will issue around $360 million of bonds along with $40 million in equity to fund the purchase of roughly $400 million of speculative-grade corporate loans. Cash flow from the underlying pool of loans are used to pay off the bonds, starting with the highest-rated debt and proceeding to lower-rated bonds. Remaining proceeds go to the equity holders.  At the same time, such managers also are betting that they can distinguish between triple-C loans that are mispriced and those that are at serious risk of default. Making the wrong bets could lead to losses for CLO investors.

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Managers of the new CLOs aren’t all pursuing the exact same strategy. While all can fill half of their portfolios with triple-C loans, two of the three—Z Capital Group and HPS Investment Partners—are largely holding back from buying triple-C loans for now to provide more room for buying in the future.  Ellington has been more aggressive, filling roughly 25% to 30% of its portfolios with loans rated triple-C by Moody’s. Its theory is that there are many triple-C loans that are already underpriced, and higher-rated loans that are overpriced, partly due to the influence of standard CLOs.

Rob Kinderman, head of credit strategies at Ellington, said his team has particular concerns about the lack of covenants, or investor protections, in most of the loans being purchased by typical CLOs.  Roughly 80% of the loans in Ellington’s CLOs have maintenance covenants, which require borrowers to meet certain tests of financial health, even though approximately 80% of loans in the market are missing those requirements.  “I’d rather have a loan that has a technical triple-C rating with covenants all day long than many slightly higher-rated loans with poor covenants,” he said.

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