CLO coronavirus stress puts institutional investors at risk, JPMorgan says
According to JPMorgan Chase & Co.’s asset management unit, secured loan obligations are under pressure and institutional investors will absorb their pain during the recession.
Downgrades of subprime business loans held by US CLOs have accelerated since the first quarter as they have “significant” exposure to sectors susceptible to the coronavirus pandemic, David Lebovitz, global markets strategist at JP Morgan said on Tuesday. Asset Management. Eighteen percent of CLO’s assets are in vulnerable sectors, including transportation, services, retail, gaming, accommodation and recreation, according to a report from JPMorgan.
“There is going to be pain,” he said.
But he says the banks, which invest heavily in the safest part of the CLO structure, will do well. “Who is going to be hurt by this?” It will be the asset managers. It will be the investors.
Historically low interest rates before the downturn left investors to do whatever they could “to get some return in their portfolios,” according to Lebovitz. This demand led to “bad behavior” in the credit markets, he said, explaining that underwriting standards for risky business loans deteriorated for years before the bull market ended.
Now that the tide has turned, insurers, hedge funds, pensions and structured credit funds face the potential for losses in the riskier parts of CLOs, Lebovitz said. As default rates will continue to rise, he predicted they might not climb as high as during the financial crisis due to the US Federal Reserve’s latest efforts to support markets.
“The problem will be on the recovery side,” Lebovitz said. Debt investors can “get back a fraction of their investment given what we’ve seen over the past decade.”
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For example, borrowers were getting away with aggressive income adjustments that made them more creditworthy, he said. It was during the good times. Today, JP Morgan Asset Management expects a 35-40% annualized decline in economic growth in the second quarter, according to Lebovitz. The next two quarters will be difficult for companies that have obtained credit where it was not necessarily due, he said.
Yet Lebovitz questioned whether the Fed’s intervention was delaying or “altogether avoiding the process of creative destruction” needed “to put the world of leveraged finance on a more stable footing” coming out of the recession.
“My biggest concern isn’t really the next 18 months – it’s that we’re covering up these cash flow issues with a variety of different types of loans,” he said. “Then we come to 2022, and we look around” to find that many companies are “zombies” that survived the downturn with a “cash injection” when they should have been “abandoned”.