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CLOInterest Summary - March 2016 Edition

Core Content

This document provides an analysis of the performance and structural features of Collateralized Loan Obligations (CLOs) and structured credit products in the context of credit risk, rating methodologies, and market trends.

Main Points

1. Cov-lite Loan Definitions and Purchase Limits

• Cov-lite loans are defined as senior secured loans without financial covenants or with maintenance covenants not in place.
• Carve-outs in cov-lite definitions have increased over time, allowing CLOs to exclude certain loans from their cov-lite purchase limits.
• This trend weakens the effectiveness of cov-lite purchase limits, as more loans are excluded from the definition, leading to underreporting of actual exposure.

2. Impact of Structural Provisions on Credit Risk

• Certain structural provisions help CLOs avoid an Event of Default (EOD) in cases of asset-settlement failures.
• These provisions are credit positive, as they protect senior noteholders from premature liquidation or acceleration.
• The new provisions in CLO 2.0s are broader and allow for more flexibility in handling settlement issues, especially when the failure is not due to the CLO's actions.

3. Structural Features in Japanese SME CLOs

• Structural features such as narrow credit event definitions and lower protection payments are key to the performance of Japanese synthetic SME CLOs.
• The Clover 2016 deal has a narrow definition of credit events, only including bankruptcy and failure to pay, and excludes loan restructuring.
• This feature is beneficial, given the high frequency of SME loan restructuring in Japan.

4. Performance of CLOs in 2015

• In 2015, US CLO issuance declined, with 182 deals rated for $92.6 billion, a 15% drop from 2014.
• European CLO issuance was more stable, with 31 deals totaling €12.6 billion.
• CLO 1.0s deleveraged significantly, leading to more upgrades than downgrades.
• Warwick subordination levels remained consistent, with Aaa (sf) classes averaging 36.5% in the US and 41% in Europe.

5. Market Outlook and Concerns

• Energy and commodity sector issues have raised concerns among investors, as they have a significant impact on CLO performance.
• CLOs with high exposures to these sectors face a higher risk of rating downgrades.
• The secondary CLO market is seen as a factor that could depress new issuance.

Key Information

• Cov-lite purchase limits have increased from 31-40% in 2012 to 51-60% in 2015, with some reaching up to 80%.
• The Clover 2011 deal outperformed due to a narrower credit event definition and limited protection payments for restructuring.
• In the Clover 2016 deal, bankruptcy and failure to pay are the only triggers for credit events, with loan restructuring excluded.
• The Japanese SME loan restructuring is very common, with over 500,000 modifications per quarter since 2010.
• The corporate default rate in Japan is at its lowest since 2001, which is positive for the performance of SME loan-backed CLOs.

Conclusion

The structural features of CLOs, particularly the definition of credit events and the inclusion of protections against settlement failures, play a crucial role in determining their performance. As cov-lite definitions weaken and purchase limits increase, the credit risk profile of CLOs becomes more complex. The performance of Japanese SME CLOs is influenced by the frequency of loan restructuring and the design of their credit event triggers. The energy and commodity sector remains a key concern for investors, highlighting the importance of manager skill and credit selection in CLO performance.