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CLO Interest Summary

Core Content

This document is a collection of feature articles and reports from Moody's Investors Service, focusing on collateralized loan obligations (CLOs) and the broader structured credit market. It includes analysis on second lien loan exposure, LIBOR phase-out impacts, and market trends in leveraged finance. The summaries and key insights are derived from Moody's research and market observations in early 2017.

Key Topics and Main Points

1. Second Lien Loan Exposure in CLOs

• Trend: Second lien loan exposures are declining in CLOs, even though they could help offset the decline in weighted average spreads (WAS).
• Credit Impact: The spread pick-up from second lien loans is not sufficient to offset the risk of lower expected recovery rates compared to first liens.
• Data:
  • Second lien exposure has fallen by 35% since November 2015.
  • Median second lien loan holding in CLOs decreased to 2.04% in June 2017, from 3.12% in November 2015.
  • WAS has fallen to 3.68% from 3.85% over the same period.
  • The largest second lien exposures are still within deal limits (5%–10% of par).
  • Symphony Asset Management LLC has the highest average second lien exposure at 4.85%.

2. LIBOR Phase-Out and Its Implications

• LIBOR Phase-Out: The U.K. Financial Conduct Authority (FCA) plans to phase out LIBOR by the end of 2021.
• LIBOR Usage: About one-third of structured finance tranches rated by Moody's are tied to LIBOR. In some sectors, the proportion is much higher:
  • U.S. CLOs: Over $300 billion in current balances tied to LIBOR.
  • U.S. subprime RMBS: Over $100 billion.
  • U.K. RMBS: Over £80 billion.
• Collateral and Swaps: Many CLOs, RMBS, and ABS are tied to LIBOR through collateral rates, interest rate swaps, or floating-rate coupons.
• Uncertainty: The credit impact of LIBOR's phase-out is uncertain due to:
  • Variability in how transactions will transition to alternative benchmarks.
  • Potential basis risk if different components of a transaction do not shift simultaneously.
  • The possibility that LIBOR may survive beyond 2021.
• Replacement Options:
  • Treasury financing rates and Sterling Overnight Index Average (SONIA) are proposed as alternatives.
  • Some approaches may be unviable or contentious, especially if they alter the cost structure or credit quality of the deals.

3. Market Observations from Moody's CLO and Leveraged Loan Conference

• Credit Quality Deterioration:
  • Leveraged loan credit quality is weakening as the credit cycle progresses.
  • Loan terms have become more aggressive, including:
    • Increased EBITDA add-backs (some as far as 2–3 years).
    • Greater borrower leverage.
    • Removal of leverage caps.
    • More flexibility to avoid paying down debt from asset sales.
  • The weighted average rating factor (WARF) cushions have shrunk, and more deals are failing their WARF tests.
• CLO Issuance and Refinancing:
  • CLO issuance is entering a new phase with increased new deals and reset activity.
  • The refinancing wave of late 2016 and early 2017 was driven by a Dodd-Frank Act exception.
  • CLOs issued before December 24, 2014 are eligible for refinancing without triggering risk-retention rules.
• Investor Behavior:
  • There has been growth in the CLO investor base, including from Asia, the Middle East, and North America.
  • Investor demand has caused liability spreads to contract sharply, especially for mezzanine tranches.
  • A CLO offered the tightest post-crisis cost of capital in June 2017, at 169 basis points.

4. Covenant Quality Trends

• Covenant Quality Index (CQI):
  • The CQI reached 4.51 in August 2017, nearly matching its record-worst of 4.52 in August 2015.
  • The index reflects weaker loan protection and increased covenant flexibility.
• Cov-lite Loans:
  • Cov-lite loans now make up three-quarters of the leveraged loan market, up from one-quarter five years ago.
  • These loans are associated with lower recovery rates during a default cycle, as subordinated debt is less available to protect senior debt.
  • The average debt cushion for recent cov-lite loans has fallen to 22%, from 33% for loans issued before the credit crisis.
  • The proportion of B3-rated companies has risen to 21%, up from 16% before the credit crisis.

Key Information

• Second lien loans are being reduced in CLOs, despite their potential to offset declining WAS.
• LIBOR phase-out poses uncertainty for many securitization sectors, including U.S. CLOs, UK RMBS, and U.S. subprime RMBS.
• Covenant quality has declined significantly, with the CQI nearing its worst level on record.
• Cov-lite loans are becoming more prevalent and are associated with lower recovery rates.
• CLO issuance has increased, driven by strong investor demand and the easing of risk-retention rules.
• Market sentiment suggests that the next credit downturn will be less severe than the 2007-08 crisis but may last longer.

Conclusion

The document highlights the evolving dynamics in the CLO and leveraged finance markets, emphasizing the decline in second lien exposure, the uncertainty around LIBOR replacement, and the weakening of covenant quality. These trends suggest a more vulnerable structured credit environment, with increased reliance on alternative benchmarks and greater credit risk in the current market structure.