Debt Market Bubble's Bursting - The 'CLO Sausage Factory' Is Stalling

Excerpted from Bill Blain's Morning Porridge commentary,

I’m intrigued by recent moves in CLOs – Collateralised Loan Obligations. They have been one of the strongest performing sectors of the bond markets for many years. Smart investors realised pooled corporate credit investments spread the risk across a wide range of borrowers, and following the 2008 Global Financial Crisis there were surprisingly few corporate defaults. In fact, as rates tumbled lower investment grade and junk debt performed strongly – making CLOs even more attractive. CLOs are now a $750 bln global market. 

But the CLO sausage factory needs constantly fed with new debt to keep churning out new product... Therein lies danger...

Most of the loans making up CLOs are junk leveraged loans – the AAA tranches get paid the interest and principal first and face the lowest risk, while profits go to the CLO equity holders. The theory is simple – although a few loans might go bust in a pool, the others will cover the losses. Have you heard that thinking before?

If you are thinking sub-prime.. give yourself a pat on the back. 

Source: Bloomberg

Suddenly there a host of doomsters warning of imminent crisis in CLOs. Bloomberg says Norinchuckin Bank has exited a large part of its CLO book following new financial regulations and greater regulator scrutiny. The Bank of Japan warned its bank charges about ratings and prices of CLOs being vulnerable to substantial falls if market conditions change. Japanese banks are said to hold 15% of the CLO market. Norinchuckin has been one of the largest players in the market – some estimates say it accounts for nearly 10% of the total market!  

There has been plenty of anecdotal evidence the quality of loans made to heavily indebted sub-investment grade companies has fallen.  The private equity owners of companies that issue the bulk of the highly leverage loans that make up CLOs have been using ultra-low interest rates to lever up companies to higher and higher levels, spurred on by demand for more and more CLOS! They’ve also been cutting covenant protections – making it simpler to finance more debt, effectively raising the credit risk of each loan, and leaving the end investors even more exposed. 

A number of investors have exited the market, concerned that highly levered, covenant lite issuers could see a far greater default rate than before in the event interest rates rise. They’re looking at some deals at the “Whoosh” end of the CLO market where the managers are willing to take greater risks as reminiscent of the Sub-Prime Mortgage crisis where Residential Mortgage Back bonds comprised loans to individuals who were very unlikely to ever be able to pay them back. 

On the other hand, a great article in WSJ this morning quotes on CLO buyer as seeing recent price slides as: “we’ve been increasing our double-B allocation in the last month”, spotting the recent sell off in CLO prices may be an opportunity.

It’s a market we’ll be watching in coming months...