20180522-穆迪服务-CLOs_–_Global__Falling_WARR_is_latest_hit_to_trading_flexibility,_ability_to_absorb_further_collateral_weakening_24页_1mb

CLO Interest Summary

Core Content

The document provides an in-depth analysis of the performance and structural changes in Collateralized Loan Obligations (CLOs) in both the US and Europe, focusing on the impact of declining weighted average recovery rates (WARR), deteriorating collateral quality, and evolving market dynamics on CLO trading flexibility and credit risk.

Main Points

1. Declining WARR and Reduced Trading Flexibility

• WARR Erosion: The weighted average recovery rate (WARR) for US and European CLO 2.0s has declined significantly since 2016, reducing the ability of CLOs to absorb further collateral weakening.
• Impact on Trading: Lower WARR levels shrink the cushion against WARR triggers, limiting the ability of CLO managers to trade off collateral quality metrics.
• Excess WARR Utilization: Many CLOs use excess WARR to increase WARF covenant levels, but further erosion could lead to breaches in both WARR and WARF tests.

2. Credit Quality Deterioration in Leveraged Loans

• Trends in Leveraged Loans: The leveraged loan universe has seen a decline in credit quality, marked by higher first-lien leverage and the proliferation of covenant-lite (cov-lite) loans.
• Impact on CLOs: This deterioration has led to a reduction in the debt cushion for first-lien loans, increasing the risk of losses for CLOs.
• Cov-lite Loans: The share of cov-lite loans in US institutional loan volume rose to 77% in 2017, while in Europe, it increased to 82% by Q2 2017.

3. CLO Performance Metrics in Q1 2018

• European CLOs: Despite some deterioration, performance metrics for European BSL CLOs remained healthy enough to support issuance.
• Credit Quality Metrics: WARF for European CLO 2.0s deteriorated by 14 points, and CLO 1.0s by 1030 points.
• Default Exposure: Median default exposure for both CLO 1.0s and CLO 2.0s remained at 0.0% in Q1 2018, though this was largely due to the low number of defaults.

4. Market Observations and Conference Insights

• Structural Weakening: CLO documentation has weakened, with features like relaxed reinvestment criteria and longer weighted average lives (WALs) becoming more common.
• 2018 Issuance Outlook: 2018 is expected to see record CLO issuance, driven by improved loan spreads and investor demand.
• Refinancings and Resets: These activities are becoming more prevalent and are helping CLOs function as permanent financing vehicles, though they can include defaulted assets and lower-quality holdings.

5. Collateral Composition Changes

• Shift to Bonds: CLO managers are increasingly considering bond investments over loans, citing better contractual protection.
• Cov-lite Exposure: Despite the prevalence of cov-lite loans, CLOs may be undercounting their exposure due to varying definitions across different CLO documents.

Key Information

• WARR Decline: Median WARR for US CLOs fell by 50 bps, and for European CLOs by 253 bps since 2016.
• WARF Deterioration: European CLO 2.0s saw a 14-point decline in WARF, while CLO 1.0s saw a 1030-point decline.
• Caa Holdings: European CLO 1.0s saw a 665-bp drop in Caa-rated holdings, while US CLO 1.0s saw a 109-bp decline.
• OC Ratios: European CLO 2.0s experienced declines in both senior and junior over-collateralization (OC) ratios due to credit-risk sales.
• Default Rates: European speculative-grade default rates improved to 2.4% in Q1 2018, with expectations of further decline to 1.1% by year-end.

Summary of Exhibits

• Exhibit 1: Median WARR and WARR cushion for European CLOs declined by 253 bps.
• Exhibit 2: Median WARR and WARR cushion for US CLOs declined by 50 bps.
• Exhibit 3: Nearly half of sampled European CLOs used excess WARR to increase WARF covenant levels.
• Exhibit 4: European CLO 2.0s had a median Caa exposure of 1.71%, while CLO 1.0s had 12.24%.
• Exhibit 5: European CLO 2.0s had a median default exposure of 0.0%, and CLO 1.0s also had 0.0%.

Conclusion

The document highlights the ongoing challenges and structural changes in the CLO market, driven by credit quality deterioration and market dynamics. While CLO performance metrics remain relatively healthy, the erosion of WARR and WARF cushions is reducing trading flexibility and increasing credit risk. The increasing prevalence of cov-lite loans and the shift in collateral composition are further complicating the market landscape. Despite these challenges, the market is expected to see significant issuance in 2018, with refinancings and resets playing a key role.