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CLO Interest Summary - August 2017

Core Content

This document provides an in-depth analysis of the Collateralized Loan Obligations (CLOs) market in August 2017, focusing on structural features, performance, and market activity. It is authored by Moody's Investors Service and highlights the evolving nature of CLOs post-crisis, regulatory impacts, and the role of CLO managers.

Main Points

1. CLO Market Overview

• The CLO market remained active in 2017, with a focus on reset and new issuance due to declining refinancing activity.
• CLO 2.0s (post-crisis deals) have become dominant, accounting for 93% of US CLOs by mid-2017.
• The market is characterized by disciplined issuance and investment in well-diversified CLOs with strong structural protections.

2. Collateral Quality and Diversification

• CLO collateral is primarily composed of first-lien senior secured loans, which are well-diversified across industries and geographies.
• Collateral quality has deteriorated slightly, with the median weighted average rating factor (WARF) of US CLO 2.0s rising to 2850, up from 2500 in 2012.
• Collateral quality tests are in place to measure and preserve key portfolio characteristics such as diversification, spread, and coupon.

3. Structural Features and Credit Enhancements

• CLO 2.0s have improved upon CLO 1.0s with enhanced credit protections, including higher over-collateralization (OC) ratios and interest coverage (IC) tests.
• The typical Aaa (sf) tranche of a CLO 2.0 has credit enhancement of 35%–38% through OC, which is higher than the 25% in CLO 1.0s.
• OC and IC tests help protect senior tranches by diverting cash flows to the most senior classes when thresholds are breached.

4. Regulatory Impact

• Post-crisis regulations, including the Volcker Rule and risk-retention rules, have significantly influenced CLO structures.
• The Volcker Rule limited non-loan investments in CLO collateral pools.
• Risk-retention rules require CLO managers to retain 5% of the risk in most transactions, which has led to strategic consolidations and the emergence of risk-retention capital providers.

5. CLO Performance

• CLOs have historically performed well, with no Aaa (sf) or Aa (sf) rated tranches in the US experiencing principal losses.
• From 1999 to 2016, only 53 US CLO tranches were impaired, with none being originally rated Aaa (sf) or Aa (sf).

6. Manager Activity and Rankings

• In H1 2017, the US and European top 10 manager lists remained largely unchanged, with a few shifts in rankings.
• The top US CLO managers by AUM and number of deals were CSAM, GSO/Blackstone, and Carlyle.
• In Europe, the top managers were Carlyle, GSO/Blackstone, and Alcentra.
• The global top 10 managers included similar firms, with Carlyle leading in CLO count and GSO/Blackstone in AUM.

7. Market Trends and Risks

• The retail sector disruption poses credit risks to certain structured finance asset classes due to the rise of e-commerce and changing customer behavior.
• CLOs have shown resilience, particularly US SME CLOs, which have been more resistant to collateral spread tightening than BSL CLOs.
• CLO managers have sought more structural flexibility, such as credit risk exchanges and deep discount obligation substitutions, which can increase credit risk if not properly managed.

Key Information

• CLO 2.0 Characteristics:
  • More diversified and conservative than CLO 1.0s.
  • Include enhanced credit protections like OC and IC tests.
  • Prohibit the purchase of structured finance instruments, synthetic securities, and equities.
• Performance Metrics:
  • Median WARF for US CLO 2.0s increased to 2850.
  • WAS (weighted average spread) dropped to a historical low of 3.65% in May 2017.
• Regulatory Impact:
  • Volcker Rule and risk-retention rules have reshaped CLO structures and market dynamics.
  • Risk-retention rules have led to strategic changes and new market participants.
• Market Activity:
  • Refinancing activity peaked in April 2017, while reset and new issuance dominated the market.
  • New CLO issuance in H1 2017 reached $36 billion, managed by 51 firms.
• CLO Performance History:
  • No Aaa (sf) or Aa (sf) tranches have ever recorded principal losses.
  • The historical average five-year cumulative default rate on B-rated collateral is around 22%, and loss severity is around 20%.

Conclusion

The CLO market in 2017 showed resilience and adaptability despite credit quality challenges. CLO 2.0s, with their improved structural features and regulatory compliance, have become the standard, offering better protection for investors. While some structural flexibility has been introduced, the market remains disciplined, with top managers maintaining their positions and a focus on maintaining collateral quality through various tests and mechanisms.