Wall Street’s response to risk in the loan market: bundle low-rated loans

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A growing number of fund managers are adopting a new strategy designed to take advantage of the volatility of bad-rated corporate loans, a sign of concern over riskier borrowers and the market that supports them.

Since November of last year, three different fund managers have issued $ 1.6 billion in enhanced secured loan bonds which are set up to hold a much larger amount of loans with extremely low credit ratings. than typical CLOs. At least two other managers are expected to follow suit in the coming months.

The emergence of enhanced CLOs underscores the growing belief among investors that the US economy is on the verge of a recession after more than a decade of expansion. It also reflects specific concerns about business loans, starting with a drop in their average credit rating. Since 2011, the amount of loans rated B or B-minus – just above near-bottom triple-C ratings – has swelled to 39% of the market, from 17%, according to LCD, a unit of S&P Global Market Intelligence.

As a result, some investors fear that even a modest economic downturn could lead to a wave of loans downgraded to triple C. This could force the sale of standard CLOs, which are designed to fill only 7.5% of their portfolios with loans. rated triple C. But it could also create opportunities for new CLOs to purchase the degraded loans with large discounts, as they can store up to half of their portfolios with triple-C debt.

“I think all kinds of people would agree that we are in the latter stages of the credit cycle. And that makes a lot of people, investors, nervous, ”said Serhan Secmen, structured credit portfolio manager at Napier Park Global Capital, during a recent roundtable on new CLOs.

In essence, CLOs are leveraged investment funds. A typical CLO will issue approximately $ 360 million in bonds along with $ 40 million in equity to finance the purchase of approximately $ 400 million in speculative grade business loans. The cash flows from the underlying pool of loans are used to repay the bonds, starting with the highest rated debt and working through the lowest rated bonds. The remaining proceeds go to the shareholders.

Investors say there is ample evidence that the limited ability of CLOs to hold triple-C loans creates unusual price movements in the $ 1.2 trillion leveraged loan market.

In one example, the price of a loan issued by business services company iQor Holdings Inc. fell from about 98 cents on the dollar to 85 cents last summer immediately after Moody’s Investors Service and S&P Global Ratings reported. downgraded the loan to triple-C. The data showed that the loan’s CLO holdings fell sharply at the time. The loan, however, has since rebounded to around 96.75 cents, according to AdvantageData.

David Kaminsky, chief financial officer of iQor, said the “downgrade of the company was dealt with quickly and with the full support of its lender base. IQor’s institutional investors backed the company through the process and offered the same terms the company initially borrowed when it increased the size of the first senior loan by $ 40 million in November of the year. last year.

Prior to November, the only asset manager to issue a CLO that could buy more triple-C loans was Ellington Management Group, which sold three for a total of $ 1.2 billion as of early 2017. Ellington has some added a fourth in February.

CLOs that can buy more triple-C loans carry risk. Because they can hold lower rated loans, structures pay higher interest rates on the bonds they issue. As a result, returns for holders of CLO shares are likely to be below average if a downturn does not occur over the next several years, creating the volatility that managers are looking for.

At the same time, these managers are also betting that they can distinguish between poorly priced triple C loans and those that present a serious risk of default. Making bad bets could result in losses for CLO investors.

The managers of the new CLOs do not all pursue exactly the 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 at this time in order to leave more room for buy in the future.

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Ellington has been more aggressive, filling about 25% to 30% of its portfolios with loans rated triple-C by Moody’s. His theory is that there are many triple C loans that are already undervalued and higher rated loans that are overvalued, in part because of the influence of standard CLOs.

Rob Kinderman, head of credit strategies at Ellington, said his team was particularly concerned about the lack of covenants, or investor protection, in most loans purchased by typical CLOs.

About 80% of Ellington’s CLO loans have maintenance covenants, which require borrowers to pass certain financial health tests, even though about 80% of loans in the market do not meet these requirements.

“I’d rather have a loan that has a triple C technical rating with all-day covenants” than many slightly higher-rated loans with poor covenants, he said.

Write to Sam Goldfarb at [email protected]

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