Downgrades In The CLO Market Leading To Higher Default Rates In 2020


In 2008, CDOs were the news of the day hitting a peak of $800 billion. Collateralized Debt Obligations are derivatives based on cash flow generating assets that are turned into investment products. These CDOs were mostly mortgage based in 2008 and went sour when housing prices and mortgage prices declined.

When mortgages declined, first the BBB-rated tranche declined and then it wiped out the AAA-rated tranche with it.

Let’s fast forward to today. We do not have a lot of mortgage-backed CDOs anymore, but we have transitioned to CLOs. CLOs are backed by corporate credit in the form of leveraged loans, unlike CDOs which are backed by mortgages. The U.S. CLO market has hit $600 billion at this time, big enough to be systemically important. The total outstanding leveraged loans on the market are around $1.6 trillion.

As these CLOs are corporate credit backed, we should be looking at corporate bond yields to assess their rating. Since 2000 to 2019, most corporate bonds have rerated to BBB corporate bonds. That’s the first omen of the worsening of the leveraged loan market.

Lately, the CLO market has seen a huge wave of downgrades. The credit quality of these CLOs has deteriorated. This trend really started in 2012 and has been worsening ever since. U.S. leveraged loan downgrades have hit a new high in 2019.

This is happening on the back of less new CLO issuances in 2019, due to widening credit spreads in the AAA tranches. It is expected that CLO issuance will continue to slow down year over year.

Moreover, the downgrades have been worsening since 2012 because most of these CLOs are covenant-lite loans (85%). What this means is that these loans have no underwriting standards and will have fewer credit protections than what they need to sustain losses. The big banks are highly exposed on these CLOs.

We see the same trend in Europe, but even worse (90%).

It is very important for investors to monitor this trend and see when the tipping point arrives, because the downgrade of these CLOs is correlated to the stock market. Whenever CLOs go bad and get downgraded, companies can get cut off from funding, initiating a tsunami of defaults. One way to monitor this tipping point is to check the CCC-rated bond yield which is typically the first to go bad (see chart below from FRED). In the 2008 financial crisis, the CCC bonds went bad first, then this spilled over into the BBB bonds and finally into the AAA bonds. Today in 2019, we can see that the CCC bond yields are rising fast while the BBB bond yields are actually still going down. I expect that the spillover into BBB bonds will happen next year based on this chart. When these spikes happen, stocks tend to move lower as credit spreads widen.

On a positive note, default rates on leveraged loans have come down recently to a seven-year low of 1%, below the 2.93% historical average. Investors should still approach the markets with caution as the consensus estimate of portfolio managers on the projected default rates has risen to 2.5% in 2020.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

2019-11-17 12:03:00

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