The Big Idea
Challenges in credit, shifts in managers, new MM appeal
Steven Abrahams, Jinzhao Wang | December 13, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Borrowers and managers relying on a benign market for credit are likely to face challenges next year. A steady but slow economy and wider spreads in ‘B3/B-‘ broadly syndicated loans should put the weakest business models at risk across market sectors and require CLO managers to navigate choppier credit. Manager performance will likely require strong credit teams and better-than-average liquidity. And the generally stronger credit in middle market loans may look good by comparison.
Testing the most leveraged credits
Some of the weakest credits in the lending market, the ‘B3/B-‘ loans making up nearly 20% of the outstanding market, should come under pressure from at least two directions next year and help steepen the CLO spread curve from ‘AAA’ down to equity. First, US growth should run slightly below 2%, good compared to the rest of the world but likely still well below the pace needed for loans underwritten to earnings expectations in mid-2018 when real GDP was running at 3.2%. The lower growth should translate into revenue shortfalls for the weakest business models across market segments and speed up repricing and migration to lower ratings. Widening spreads on ‘B3/B-‘ loans this year should add to the pressure. Borrowers with approaching maturities or trying to extend their debt stand to face much wider spreads than their current loans’. For loans originated before mid-2018, current LIBOR and wider spreads could mean higher absolute rates. Unless the borrower finds some way to deleverage, ratios of earnings-to-interest-expense should come under pressure. Low prices on ‘B3/B-‘ loans that get downgraded to ‘CCC’ could also lead some issuers to buy back some or all of their debt, triggering a rating agency downgrade of the issue. Volatility in loan spreads and ratings should add a risk premium to the CLO equity and lower rated debt most sensitive to portfolio market value. Migration up in the capital structure by some investors along with inflows from investors looking for yield should tighten senior debt spreads. The CLO spread curve should steepen.
Reshuffling of CLO manager performance
Volatility in leveraged loan credit next year looks set to keep reshuffling CLO manager performance, opening up sizable gaps in value across CLO equity and lower-rated debt. Some managers with longstanding reputations for good performance fell hard in 2019 while others managed to keep their records intact. The correlation between managers’ excess returns on their leveraged loan portfolios for the 12 months ending in November 2018 and for the 12 months ending November 2019 was low (Exhibit 1). Managers with the most reliable 12-month performance from November 2018 to November 2019, at least measured by excess return over the broad loan market, generally had broad and deep teams of analysts often with some roots in distressed investing. Managers with less reliable records tended to come from shops with fewer resources. The loan market next year will likely keep challenging managers with a heavy supply of ‘B3/B-‘ loans, ratings migration and price volatility. It looks unlikely that managers will be able to avoid the challenges by moving up into the limited supply of better credits. Managers will likely need strong credit staffs, broad diversification and reasonable liquidity to have a chance to do well. Investors should also look for deals with relatively low price sensitivity to the broader loan market since those portfolios will tend to have more stable MVOC. Opportunity for relative value trading across managers should be robust with the biggest distinctions coming in equity and speculative-grade CLO debt.
Exhibit 1: Managers’ good portfolio alpha in ‘18 did not predict good alpha in ’19
The increasing appeal of middle market CLOs
The attention to credit next year in CLOs backed by broadly syndicated loans should unintentionally reflect well on CLOs backed by middle market loans. The better middle market CLO managers still tend to originate their own paper, get ample covenants and actively use them to monitor and, if need be, restructure the debt. Tight control should keep expected recoveries strong, including the ability to restructure a weakening loan into a higher coupon and tighter covenants and sell it for par. But careful review of the manager, its portfolio track record, typical covenants and loss mitigation strategies is important.
Wider spreads for the same rating in middle market CLO debt reflect, among other things, both the lack of transparency on the loans and the lower liquidity of the debt. Transparency and liquidity differences could narrow next year if volatility in ‘B3/B-‘ debt materializes. Better credit in the collateral backing middle market CLOs from the best managers should make the spread difference attractive.
The underlying consensus
Other aspects of the CLO market seem widely anticipated. Expectations for new issue volume range between $75 billion and $90 billion. Investment in CLO equity is expected to continue moving away from hedge funds and toward managers and outstanding risk-retention vehicles. Demand for CLO debt from money managers, pension funds and other total return portfolios is likely to increase.
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