Key Points
- We expect defaults of leveraged loans in the region of USD 100bn over 2020 and 2021;
- These will likely lead to significant losses to CLO bondholders; in particular to investors in equity, B and BB tranches;
- While the biggest unknown in our analysis is whether macroeconomic policies will succeed in bailing out leveraged borrowers, our analysis cautions CLO investors on the potential downside they face and urges them to take early steps to protect their position;
- CLO and CDO litigation that ensued the Global Financial Crisis provides a very good indication of the types of disputes between CLO managers, dealers and bondholders that are likely to emerge;
- We provide a framework for all parties involved in these transactions on the necessary steps they must take to protect their position.
Market Background
Leveraged Loans
The global leveraged loan market size, as of December 2019, was estimated to be approximately USD 1.4 trillion1. The outstanding amount of leveraged loans has almost doubled since the Global Financial Crisis. Lending standards have eroded with the share of covenant-lite loans increasing and a deterioration in credit quality.
Since 2008, the outstanding amount of leveraged loans has grown by approximately 80%2. At the same time, the quality of the loans has steadily declined:
- Approximately 80% of loans issued in 2019 were covenant-lite, or had no covenants3;
- The portion of B rated loans has increased by 23% since 20094
- Approximately 57%5 of the stock of outstanding loans are currently held by CLO vehicles.
Collateralized Loan Obligation (CLO) Investors
Depending on the tranche of bonds, there are different categories of investors involved in the CLO bond market:
- Hedge Funds are the largest owners of equity tranches, the riskiest tranche of CLO bonds;
- Open-ended funds (UCITS and mutual funds) and insurance companies hold the majority of mezzanine tranches;
- Banks are the largest owners of AA and AAA rated CLO bonds.
Source: Bank of England, Fideres
Impact of the COVID Crisis on CLOs
What Is the Likely Impact of the COVID Economic Crisis on CLOs?
In a recent report6, Fitch estimated that approximately 11.80% of loans held by CLOs are at high risk of default while 35.5% are classed as medium risk.
Leveraged loan default rates were relatively mild in the aftermath of the Global Financial Crisis as a result of the aggressive monetary easing central bank policies. Back in 2008, LIBOR represented 77% of the overall interest rate cost to borrowers. Now, that portion is only 32%. Therefore, even a reduction of interest rates will not make interest payments affordable to highly leveraged borrowers who are witnessing their revenues collapse.
As a result, we expect the current economic crisis to result in significantly higher default rates, and for a longer period of time, than what were observed during the Global Financial Crisis. Given the lower credit quality of the loans, and the prevalent covenant-lite nature of the loans originated in the last ten years, we also expect recovery rates to be significantly lower than historical ones.
Our scenario analysis assumes:
- Default rate of 15% in 2020 and 10% in 2021
- Recovery rate between 40% and 50% on defaulted loans
What Does this Mean for CLO Investors?
The table below summarises our expectations of losses for each tranche of CLO bonds.
Future Litigation
We expect to see the following litigation themes to emerge:
- Litigation by investors (individuals and institutional) against open-ended fund managers who have frozen redemption of their funds investing in distressed, hard to value assets;
- Claims brought by portfolio managers against banks seeking additional margin calls, the liquidation of loan warehousing facilities, close-out of derivative contracts;
- Claims for breach of fiduciary duties against CLO managers;
- Claims by investors against deal arrangers for lack of compliance with the EU Prospectus Regulations;
- Claims against Credit Rating Agencies (CRAs), under the new EU regulations.8 9
Sources:
- Differences in the criteria and thresholds applied by data providers to identify a leveraged loan leads to different estimates of the size and other characteristics of the market, even within the same jurisdiction; Source: https://www.fsb.org/wp-content/uploads/P191219.pdf
- Bank of International Settlements, https://www.bis.org/publ/qtrpdf/r_qt1909.htm
- S&P Leveraged Commentary & Data
- Bank of England: https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2019/july-2019.pdf?la=en&hash=976688AB50462983447A8908BE079743A3E3905F
- Bank of England: https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2019/july-2019.pdf?la=en&hash=976688AB50462983447A8908BE079743A3E3905F
- Fitch Ratings: https://www.fitchratings.com/site/pr/10112736
- We assume that USD 800bn across CLO tranches are outstanding; 1.6% average excess spread ; typical CLO capital structure of 7.5% equity, 5% BB tranche and 5% BBB tranche and default rates jump to 15% in 2021 and 10.5% in 2021
- Title IIIa of Regulation No 462/2013
- Regulation No 462/2013 and Directive 2013/14/EU
Alberto is a founding partners of Fideres, with over 21 years of cumulative industry experience.
His area of expertise is complex antitrust investigations and regulatory advisory work. He has handled some of Fideres’s largest and most complex economic investigations into the collusive practices of the financial industry, including ISDAfix and LIBOR benchmark manipulation, Generic Pharmaceuticals Cartel case and, more recently, abuse of dominance cases against monopolistic digital platforms. Before founding Fideres, he held senior managerial positions in New York and London at investment banks including UBS, ABN AMRO and The Royal Bank of Scotland. His investment banking expertise was in in fixed income bonds and derivatives markets, with a specialty in structured products.
Alberto holds master-level degrees in Engineering from Politecnico di Torino and from Ecole Centrale Paris.
