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CLOInterest - December 2015 Edition Summary

Core Content Overview

This report provides a comprehensive outlook on the performance of Collateralized Loan Obligations (CLOs) in 2016 across the US, European, and Asian markets, including a specific focus on Chinese CLOs. It also discusses the impact of regulatory changes, such as the EU risk retention rules, and the role of market dynamics like underwriting standards, liquidity, and interest rates on CLO performance.

Main Points and Key Information

US CLOs

• Performance Outlook: US broadly syndicated loan (BSL) CLOs will continue to perform well in 2016, with loan defaults increasing modestly but remaining low.
• Credit Quality: While underwriting standards have tightened, the credit quality of the overall loan universe will not see significant improvement due to the increased issuance of lower-rated loans.
• Default Rate: The US speculative-grade default rate is expected to rise gradually to 3.8% by October 2016 from 2.8% in October 2015.
• Covenant Erosion: Covenant-lite (cov-lite) loans are more vulnerable to lower recovery rates due to reduced debt cushions.
• New Issuance: New CLO issuance will decline due to constrained leveraged loan supply and the impact of Dodd-Frank risk-retention rules set to take effect in 2016.
• Structural Protections: CLO structures remain robust, and existing transactions will benefit from deleveraging and reinvestment strategies.
• Interest Rates: Rising interest rates will slightly reduce excess spread due to the loss of LIBOR floor benefits, but this impact will be limited as LIBOR is expected to rise to 1.0% in 2016.

SME CLOs

• Performance: SME CLOs will largely mirror BSL CLO performance, despite some differences in underlying loans.
• Covenant Quality: SME loan covenants are expected to remain relatively strong, though increased competition may lead to weaker credit quality for large SME borrowers.
• Portfolio Dynamics: SME loans typically have lower ratings and wider spreads, and their inclusion in CLO portfolios will be limited due to investor resistance.

European CLOs

• Performance Outlook: European CLOs will also perform well in 2016 due to low default pressure and continued low interest rates.
• Default Rate: The European speculative-grade default rate is expected to rise slightly to 2.7% by October 2016, up from 2.4% in October 2015.
• Debt Maturity: Most European debt maturities have been pushed out to 2019 and beyond due to refinancing activity.
• CLO Structures: New European CLO structures will remain sound, with features like multi-currency deals and rated warehouses becoming more prominent.
• Deleveraging: Amortizing CLOs (CLO 1.0s) will benefit from deleveraging, with OC levels rising and some deals expected to fully pay down liabilities in 2016.

Asian (Ex-Japan) CLOs

• Performance: The region will continue to perform well, supported by low default rates and regional diversification.
• Chinese CLOs: Chinese CLO credit quality is expected to deteriorate due to slowing growth and worsening corporate credit profiles.

Regulatory Impact

• Risk Retention Rules: US CLOs using an originator structure will face increased exposure to the originator's insolvency due to the EU risk retention rules.
• Volcker Rule: CLOs may need to amend their structures to comply with the Volcker Rule and other regulations.

Market Trends

• Investor Demand: There will be increased demand for slightly longer-term CLO deals, with non-call periods, reinvestment periods, and portfolio weighted average life (WAL) covenants extending.
• Collateral Quality: Reinvesting deals will continue to meet collateral quality covenants, while amortizing deals will see some decline in portfolio credit quality due to prepayment of better quality assets.
• Covenant Flexibility: CLOs will show flexibility in covenant structures, allowing for trade-offs between WARF, WARR, and WAS.

Key Figures and Statistics

• Default Rate: US speculative-grade default rate expected to rise to 3.8% by October 2016.
• Debt Cushion: Cov-lite loans originated in 2014 have a debt cushion of less than 20%, compared to 33% for those issued between 2005 and 2008.
• LIBOR Floors: Over 95% of leveraged loans have LIBOR floors, with an average of approximately 1.0%.
• OC Levels: Median senior OC level for US amortizing CLOs is 182%, compared to 135% for reinvesting CLOs.
• CLO 1.0s: About two-thirds of European CLO 1.0s currently violate their WARF covenants.

Conclusion

Despite challenges such as declining loan supply, increased risk exposure from regulatory changes, and the impact of rising interest rates, US, European, and Asian CLOs are expected to maintain solid performance in 2016. The structural resilience of CLOs, combined with continued deleveraging and refinancing strategies, will support their credit quality. However, the credit quality of Chinese CLOs is anticipated to decline due to economic and corporate credit pressures.