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CLO Interest Summary

Core Content

This document provides an in-depth analysis of the performance and trends in the Collateralized Loan Obligations (CLOs) market for the third quarter of 2017, focusing on both the United States and European markets. It outlines key developments in CLO issuance, recovery rates, covenant structures, and credit metrics, while also discussing the implications for investors and CLO managers.

Main Points

US CLO Sector Update – Q3 2017

• Macro Volatility Indicators: Remained stable, with low levels of financial stress and volatility.
• Leveraged Loan Issuance: Continued to be robust, with cov-lite loans accounting for over 80% of institutional issuance.
• CLO Issuance Volume: Increased to $93.6 billion by the end of Q3 2017, surpassing the full-year 2016 total of $88.3 billion.
• Credit Quality Metrics: Mixed, with a decline in recovery rate estimates and an increase in Caa-rated holdings.
• Portfolio Performance:
  • WARR: Declined for CLO 2.0s to 49.2% in June 2017 from 50.9% in January 2012.
  • WARF: Improved slightly for CLO 2.0s, while US CLO 1.0s saw a significant increase.
  • OC Levels: Declined for European CLO 2.0s but increased for others, mainly due to amortization.
• Credit Risk: Caa exposures rose, and the downgrade of Concordia International Corp. contributed to this trend.

European CLO Sector Update – Q3 2017

• Leveraged Lending Volume: Surpassed the full-year 2016 total, showing strong issuance.
• Credit Quality: Improved, with the Liquidity Stress Indicator at a historical low.
• CLO Performance Metrics:
  • WARF: Median WARF for European CLO 2.0s worsened to 2721 from 2706.
  • OC Levels: Declined for European CLO 2.0s but improved for others.
• Risk Factors: Geopolitical risks remained elevated, though macroeconomic indicators were generally positive.

Shrinking First-Lien Cov-Lite Debt Cushions

• Cov-Lite Loans: Dominated the leveraged loan market, with 75% of new institutional loan issuance in 2016.
• Debt Cushion Decline: Average debt cushion for first-lien cov-lite loans dropped from 28% in 2012 to 22% in 2016, leading to lower recovery rates.
• Impact on CLOs: Reduced WARR cushions and lower recovery rates increase risk for CLO tranches, especially junior notes.
• CLO Exposure: Around 80% of rated CLOs had greater than 10% exposure to cov-lite loans without subordinated debt.

Leveraged Loan Covenants – North America

• Restricted Payment Protections: Weakened, with a risk category score of 4.42, close to its record-worst.
• Dividend Capacity: Borrowers have greater flexibility to pay dividends and other equity payouts, increasing cash leakage for loan investors.
• Covenant Structures: Ratio-based restricted payment baskets are now used in 95% of leveraged loans, up from 49% in 2015.
• Dividend Leverage: Borrowers can use up to 60% of EBITDA for dividends under fixed baskets, with cash balances averaging 4% of total assets.

August 2017 Market Pulse

• Defaults: Declined across all cohorts, with US CLO 1.0s seeing the most significant drop.
• Caa Exposures: Increased for US CLO 1.0s and European CLO 2.0s, driven by downgrades and amortization.
• WARF and OC Trends:
  • US CLO 1.0s' WARF increased significantly.
  • European CLO 2.0s' OC levels declined, while others increased.
• CLO 2.0 Performance:
  • Median WARR for US CLO 2.0s was 49.5%.
  • Median recovery rates for cov-lite loans without subordination were around 45% or less.

October 2017 Surveillance Update

• Rating Upgrades: Driven by deleveraging, with eight branches upgraded from five transactions totaling $175 million.
• Upgrades Range: From one to three notches, with an average of 2.0 notches.
• Impact of Deleveraging: Improved OC ratios due to repayment of senior notes using principal proceeds.
• Refinancing Benefits: Increased excess spread and WARR for some CLOs, leading to rating upgrades.
• Downgrades: Occurred due to collateral deterioration and lower portfolio spreads.

Key Information

• CLO Recovery Rates: Declined due to reduced debt cushions, especially for cov-lite loans without subordination.
• CLO Issuance: Continued to grow, with a notable increase in 2017 compared to 2016.
• Credit Metrics: Mixed for US CLOs, with some improvements in liquidity and downgrade-to-upgrade ratios.
• Covenant Trends: Weakened restricted payment protections allow greater dividend capacity, increasing risk for loan investors.
• Portfolio Composition: CLOs increasingly hold cov-lite loans, which have lower recovery rates and less subordination.
• Market Outlook: Credit risk remains elevated, with Caa exposures increasing and potential for lower recoveries in future downturns.

Conclusion

The CLO market in 2017 showed mixed performance, with strong issuance but declining recovery rates and increased credit risk. The rise of cov-lite loans, which have weaker debt cushions and less subordination, has contributed to lower portfolio recovery rates. Meanwhile, covenant structures have weakened, allowing borrowers more flexibility in paying dividends, which increases risk for loan investors. Deleveraging and refinancing have driven some rating upgrades, but overall credit quality remains a concern.