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CLO issuance rises slightly in second quarter amid loan downgrades

Kristen Haunss

By Kristen Haunss

NEW YORK, July 13 (LPC) - Issuance of US Collateralized Loan Obligations (CLOs) rose slightly in the second quarter amid downgrades to the funds' loan holdings caused by the coronavirus pandemic, putting pressure on the market.

There was US$18.1bn of US CLOs arranged during the past three months, up from US$15.7bn in the first quarter, according to LPC Collateral data. After issuance dropped to US$3.4bn in March, the lowest monthly tally since January 2017, the asset class started to see life again and US$8.2bn of deals priced in June.

The US$693bn US CLO market is the largest buyer of US leveraged loans. A healthy CLO market can back mergers and acquisitions, and support companies' daily activities. But as the coronavirus pandemic swept the globe shutting supply chains and drying up consumer demand amid government-ordered shutdowns, many companies that depend on the leveraged loan market experienced a slowdown in business.

The credit rating firms responded by downgrading a significant number of borrowers, putting pressure on CLOs that can only hold so many low-rated loans before they trip tests that can eventually cut off payments to the funds' investors.

"It has been a bit of a roller coaster ride with the liquidity unwind of March and loans really leading CLOs lower all the way through now where you have seen a fair bit of retracement back to pre-Covid levels," said Chris Long, chief executive officer of asset manager Palmer Square Capital Management.

The CLO market opened in January with US$4.07bn of issuance followed by US$8.25bn in February as companies took advantage of a borrower-friendly market to cut interest payments. More than US$126bn of US institutional loans were refinanced in the first quarter, according to Refinitiv LPC data.

But as coronavirus began to spread around the world, market volatility hit the CLO and loan asset classes.

CLO tranche spreads gapped out as leveraged loan prices fell to an almost 11-year low. The LPC 100, a cohort of the 100 most liquid US loans, dropped more than 21% from the start of the year to 77.87 cents on the dollar March 23. It sat at 93.6 Friday.

Volume started to pick back up in the second quarter with US$3.9bn of CLOs issued in April, almost US$6bn in May and US$8.2bn in June.

"CLO issuance re-started in April/May as liability spreads recovered and investor confidence returned to some degree," said Rishad Ahluwalia, JP Morgan's London-based head of CLO research.

In the second half of the year, Rachel Russell, head of CLO syndicate at Morgan Stanley in New York, expects spreads, particularly on the senior tranche, to grind tighter.

"Real money investors appreciate the credit enhancement within Triple As and the volatility over the last few months illustrates the structural protections built into CLOs," she said.

Some senior CLO tranches priced below 170bp in June, according to LPC Collateral.


In response to the pressure companies experienced as a result of the pandemic, ratings firms downgraded a significant number of businesses whose loans are held by CLOs. In turn, rankings on the vehicles' tranches have been put under review.

S&P Global Ratings has placed about 13.9% of its outstanding US CLO ratings on creditwatch with negative implications. At the same time, more than 1,000 classes of US CLO tranches are being considered for downgrade by Moody's Investors Service.

The downgrades have forced investment firms to be nimble in responding to market conditions.

"When I look at everything we have gone through, the events of the first half of the year highlight one of the key features of CLOs – these are actively managed vehicles," said Russell. "This will be an opportunity for CLO managers to differentiate themselves, through credit selection, trading decisions and portfolio management."

As the market has steadied, many participants are more optimistic.

Wells Fargo at the end of June, raised its 2020 US CLO issuance forecast to US$65bn, up from its revised prediction of US$50bn on May 4. Its original 2020 forecast was US$90bn.

But questions about the broader economy and the health crisis continue to weigh on managers.

"As far as the levers in our control – the quality, duration, issuer diversification – we are keeping those to the more conservative end," Long said. "It's like managing the unknown unknows. That is quite a challenge for a CLO manager." (Reporting by Kristen Haunss; Editing by Michelle Sierra)