“Consider what will happen if that mountain of B-rated loans goes through a downgrade cycle,” said Oksana Aronov, head of market strategy for Absolute Return Fixed Income at JPMorgan Asset Management. “The CLO market cannot absorb this quality deterioration, so those loans will end up sloshing around looking for a buyer in a market.”
CCC loans pay a higher yield to compensate for the risk, and CLOs that can buy them may generate higher gains for investors. But picking the right credits will be important, because CCC loans may also fail in greater numbers. It remains to be seen how much appetite investors will have for these CLOs, said Z Capital’s Curtis.
“With each deal that gets done, the market expands and it’s so far so good,” Curtis said. “Will every manager want to do them? We think the structures are well-suited to those comfortable investing in lower-rated and stressed loans, and we don’t know if that fits every CLO manager.”
Deals like HPS’s are essentially betting that the loans that CLOs sell will fall into a void: prices will be depressed by the forced sale, but won’t be sufficiently bad to be attractive to distressed funds.
To help ratings agencies get comfortable with the deals, the CLOs have a fatter equity chunk that serves as a cushions against defaults. That reduces the amount of leverage in the structured deals. For example, leverage in HPS’s CLO is about 5.5 times compared to a traditional CLO of 14.3 times, according to a document seen by Bloomberg.
Still, Moody’s estimates a higher possibility of default and lower recovery rate on one of Ellington’s CLO deals compared with traditional CLOs. It estimates an average default rate of 4.5 percent for ten years and a 42.5 percent recovery rate on the deal the asset manager sold in July.
Some loan investors anticipate a disorderly tumble when B-rated issuers get downgraded. But for Ellington, it’s a buying opportunity.
“This triple C bucket is a big vulnerability in regular-way deals,” said Rob Kinderman of Ellington Management Group, the investment manager held up as the pioneer of this structure. “And they’re likely to hit vulnerability all at the same time.”
This article provided by Bloomberg News.