http://www.zerohedge.com/news/2016-02-21/next-shoe-just-dropped-equity-navs-348-clos-slide-below-zero-market-changed-dramatic
The implications is that with the CLO product suddenly abandoned, lower issuance of CLOs, the main buyers of leveraged loans, will make it harder for companies to issue new debt in the already-challenged US$870bn US leveraged loan market which provides junk loans to companies including retailer Dollar Tree and countless near-distress shale companies.
A quick prime on the current iteration of the collateralized loan oblitation market: CLOs are typically allowed to hold around 7.5% of loans with ratings of Caa1/CCC+ or lower, according to Deutsche Bank, which makes mass credit downgrades difficult for some managers. About 15% of funds have lower limits of 5%.
When low-rated loans exceed those limits, CLOs get a haircut in overcollateralization (OC) tests, which mean that the loans may have to be marked down to market value rather than par or face value. The test measures the value of funds' assets compared to its debt and if CLOs fail, interest proceeds are used to repay debt investors. CLOs pool loans of different credit quality and sell slices of the fund of varying seniority, from Triple A to B, to investors such as insurance companies. The equity slice, the most junior and riskiest part of the fund, is paid last after bondholders.
Among the S&P report findings is that 209 US CLOs issued since the credit crisis have an average exposure of 0.69% to one or more of the 45 companies downgraded by S&P. Among these are Fieldwood Energy, held by 140 CLOs, which was downgraded to CCC from B. Templar Energy is held by 72 funds and had its rating cut to CCC- from B-.
“A number of names have been lowered to the CCC bucket, which could affect OC tests if the CCC thresholds are breached,” said Jimmy Kobylinski, an S&P analyst.
It's just the beginning: as the number of downgrades rises, CLO impairments will propagate in an exponential fashion. Already the number of companies with a low B3 rating and a negative outlook or lower rose to 264 as of February 1, just 27 issuers below an all-time high in April 2009, according to a February 3 note from Moody’s. Oil and gas borrowers make up 28% of the list.
The growing list, formerly known as the “Bottom Rung,” shows deteriorating credit quality and points to a rising default rate in 2016, Moody’s analysts said. The ratings firm is expecting the US speculative-grade default rate to rise to 4.5% in 2016.
Heavy energy exposure is also starting to weigh on CLO ratings, Reuters adds. A tranche of a post-crisis CLO was downgraded last month when S&P cut the Class E notes of Silvermine Capital Management’s ECP 2013-5 to B- from B. Analysts said that the fund had credit deterioration in the collateral portfolio and a large exposure to the energy sector.
It has gotten so bad that Wall Street, which traditionally has no idea what is going on until it is too late (and then rushes to blame the rating agencies) has started asking questions: "People are definitely trying to get their heads around what [increased CCC holdings] says about the credit cycle,” said Chris Flanagan, head of US mortgage and structured finance research at Bank of America Merrill Lynch in New York. “The market has changed dramatically in just six weeks.”
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To help the market appreciate the severity of the above, according to a recent update from Morgan Stanley, 2015 was the first post-crisis year in which distress in the CLO market surged. During this year, CLO equity turned from a well-sought, 10%+ return asset class into a space red-flagged with cautions and concerns. While cash distributions managed to remain at ~20% annualized, NAV collapsed across all vintages with the pain most pronounced in 2013-14 deals, the median NAVs of which currently stand at near-zero levels.
The punchline is that this trend not only continued but accelerated dramatically in January 2016 - median CLO 2.0 equity NAVs tumbled by 9 percentage points, or by 85%, and according to Morgan Stanley calculations as of January 2016, a whopping 348 US CLO 2.0 deals’ equity tranches currently having NAV below zero.
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