Canary, Meet Coal Mine: These Are The Tranches Where The CLO 2.0 Meltdown Begins

It was just three days ago when we brought you what we called “the next shoe to drop:” CLOs.

The market for collateralized loan obligations dried up completely in the wake of the crisis, as just about the last thing anyone wanted anything at all to do with was paper “secured” by leveraged loans.

But Wall Street (not to mention investors) never learn and supply came storming back in 2012. Within two years, issuance was running at a $124 billion per year clip. For reference, that’s about the same amount of supply that came to market last year in the auto loan-backed ABS space.

Issuance slipped in 2015 and in Q1 2016, it’s fallen off the map.

Why? Simple: the collateral pools are littered with the kind of "assets" you might not want in the current environment. Like exposure to US energy companies whose prospects are increasingly bleak. According to S&P, the credit ratings of some 1.4% of assets held by US CLOs have been downgraded or placed on credit watch negative this year. Similarly, Moody's notes that 12.6% of CLO assets carry a negative outlook - that's up 2.2% in just three months

As we noted on Sunday, performace is suffering mightily - especially in certain buckets. "Based on our sample, we estimate that the median total return for US CLO 2.0 (2014-15 vintage) BBs is -9.2%, and for single-Bs is -20.9%," Morgan Stanley wrote, in a recent report. "Investment-grade US CLO tranches performed better but still within negative total return territory, except for AAAs."

Performance woes are compounding the problem for a space that was already facing a looming regulatory headache in the form of the 5% risk retention rule which, in an effort to ensure managers have "skin in the game" so to speak, will effectively cause a third of CLO managers to either attempt to consolidate with bigger players with deeper pockets, or else curb issuance. The is made all the worse by the fact that compelling managers to take a 5% stake in the first loss tranche effectively forces them to have more than 5% skin in the game. After all, it's the first loss tranche.

And all of that is on top of soaring funding costs:

Just hours after our "next shoe to drop" warning, Moody's followed in S&P's footsteps and delivered their first downgrade of post-crisis US CLOs. In the crosshairs: Silvermine Capital or, more specifically, Silvermore CLO and Silver Spring CLO where exposure to junk debt and the increasingly toxic O&G space is worryingly high.

"In two of the three deals, the exposure has even increased somewhat from the initial portfolio," Deutsche Bank notes.

Here's the tranche-by-tranche breakdown:

"In market value terms they have lost a lot of value but the actual test par erosion is still very limited, so there is a large amount of implied losses but still some runway to go before payments to equity get cut off," Deutsche cheerfully notes.

We're reminded of what Morgan Stanley said last week: "... we reiterate our view that the levels of distress in the US market may create “option-like” payoffs in CLO equity in the secondary market, especially in deals by managers who are better 'credit pickers.'"

So who's a buyer?

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Bonus chart: monthly US CLO issuance