The Journal of Structured Finance 1Summer 2020

Mark adelson

is the editor of The Journal of Structured Finance.m.adelson@pageantmedia.com

CLO Conference Notes 2020Mark adelson

ABSTRACT: CLOs and Leveraged Loans 2020 was a virtual (online) event held June 16–17, 2020. Many of the speakers and panelists expressed strongly positive outlooks for the CLO and leveraged loan sectors. Although the economic fallout from the coronavirus pandemic was a central theme in many sessions, the dominant view was that leveraged loans and CLOs will be able to weather the storm. Sessions covered include:

• Get to Know Your CLO Manager! • Opening Keynote: The Longest US Eco-

nomic Expansion Comes to an End• The Evolution of CLO Documentation

Standards• CLO Master Class for Allocators• The New Normal: Evolution of the 2.0

CLO Manager• LIBOR Transition in a Covid-19 World:

Preparation Amidst the Chaos• Mezzanine Investor Roundtable: Getting

Your Cash Back to Work!

The recent CLOs and Lever-aged Loans 2020 was a virtual (online) event held June 16–17, 2020. Many of the speakers and

panelists expressed strongly positive out-looks for the CLO and leveraged loan sec-tors. Although the economic fallout from the coronavirus pandemic was a central theme in many sessions, the dominant view was that leveraged loans and CLOs will be able to weather the storm. A number of speakers mentioned and criticized a recent article in The Atlantic (Partnoy 2020) that took a notably bearish view of the CLO sector. On the other hand, speakers did not mention the forthcoming article by NYU professor Ed Altman (Altman, forthcoming), which also expresses a bearish outlook.

Given current economic conditions, it is probably worth recalling some of the key statistics reported by the rating agencies. Exhibit 1 shows selected average cumulative

• The CLO and leveraged-loan markets have withstood the stresses of early 2020 and are well positioned to handle further stresses that may appear.

• CLO notes, especially highly-rated notes from recent vintages, have high levels of credit enhancement and other structural protections that enable them to survive adverse scenarios.

• Still, tail risk remains. A double-dip recession or a second wave of COVID-19 could derail expectations and lead to tail-risk scenarios.

KEY FINDINGS

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2 CLO Conference Notes 2020 Summer 2020

default rates reported by Moody’s and S&P for time horizons ranging from 5 to 12 years:

Of note, about half of the leveraged loans in CLOs are at or below the B2/B credit level, and about half are in industries with at least moderate exposure to the coro-navirus pandemic. It is also worth recalling that actual default rates in any given year can vary signif icantly from the average. During periods of stress, defaults rise markedly (Exhibit 2).

US CLO issuance remained quite strong until the onset of the coronavirus pandemic (Exhibit 3). It remains to be seen what the level of new deal activity will be in 2020 and 2021.

The following summaries ref lect remarks of the speakers and panelists who participated in selected sessions of the event. For the most part, the summaries are drawn from notes I took during the sessions. Unless otherwise indicated, the summaries ref lect the panelists’ remarks and not my views. The summaries have not been reviewed or approved by the panelists. While I have tried to capture panelists’ remarks accurately, I apologize in advance for any inaccuracies and omissions. The exhibits interspersed among the summaries were added by me and are not exactly the same as the slides shown by the panelists in their presentations. I wish to acknowledge the excellent work of Information Management Network in orga-nizing and hosting the conference.

TUESDAY, JUNE 16, 2020

9:30 p.m.—Get to Know Your CLO Manager!

One panelist asserted that there are opportunities in the CLO sector. There is elevated risk but also the opportunity for higher returns. When his firm analyzes a leveraged loan, it emphasizes downside scenarios. The pricing on loans is very attractive right now, so there is a favorable balance of return versus risk. He favors bor-rowers with sticky (stable) revenue streams that are not highly correlated with GDP growth. Insurance brokers

SESSIONS COVERED Page

Tuesday, June 16, 2020Get to Know Your CLO Manager! ................. ................. 2Opening Keynote: The Longest US

Economic Expansion Comes to an End ....... ................. 4The Evolution of CLO Documentation Standards ............ 9

Wednesday, June 17, 2019CLO Master Class for Allocators ..................... ............... 10The New Normal: Evolution of the 2.0 CLO Manager ...11LIBOR Transition in a Covid-19 World:

Preparation Amidst the Chaos ...................... ............... 12Mezzanine Investor Roundtable: Getting

Your Cash Back to Work! ............................ ............... 13

e x h i b i t 1Selected Rating Agency Cumulative Default Rates (%)

Sources: Ou et al., 2020, Exhibit 46. Kraemer et al., 2020, Table 14.

Moody’s Average Cumulative Issuer-Weighted Global Default Rates by Alphanumeric Rating, 1983–2019

S&P US Corporate Average Cumulative Default Rates by Rating Modifier, 1981–2019

Years

Ba2Ba3B1B2B3Caa

BBBB–B+BB–CCC/C

5

6.0512.2215.6120.3125.5331.26

6.9010.0515.0517.7228.1051.62

6

7.2114.7418.7223.6329.4135.08

8.3612.0217.0220.0430.2952.81

7

8.3117.1521.7726.4332.6538.30

9.6313.6618.8821.5931.9454.27

8

9.4819.3924.4628.6935.5841.29

10.7415.3420.5122.6433.1555.14

9

10.8221.4626.8730.8238.1244.02

11.7116.7222.0023.6633.8855.95

10

12.1923.5028.8432.8640.0646.29

12.6117.9223.3824.6334.5856.63

11

13.4025.2030.5934.6241.7248.01

13.5318.8224.5125.3835.3657.26

12

14.6026.9632.0636.5542.9548.99

14.2719.6925.2826.2235.8357.78

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The Journal of Structured Finance 3Summer 2020

are examples of attractive borrowers, while oil and gas companies and those in the automotive sector are not.

Another panelist emphasized the risk in the market but also noted that the environment creates potential opportunities. Some companies will have “V” shaped recoveries while others will experience an “L.” Moreover, even within industries, there are different expectations for

different subsectors. For example, the fast-food subsector is doing well while other types of restaurants are not. Also, prices have recently rallied on some recently-originated loans (e.g., Delta Airlines), showing that there were recent bargains. However, the rally means that there are fewer attractive opportunities now.

e x h i b i t 2 Moody’s Global Issuer-Weighted Speculative-Grade Default Rate

Source: Ou et al., 2020, Exhibit 3.

0%

2%

4%

6%

8%

10%

12%

14%

16%

1920 1930 1940 1950 1960 1970 1980 1990 2000 2010Year

e x h i b i t 3US CLO Annual Issuance (US$ billions)

Notes: 2020 data through mid-June. Does not include refis and resets.

Source: Asset-Backed Alert.

30.6

56.1

106.7

95.6

22.0

55.6

86.8

123.

9

100.9

74.7

118.0

133.

3

122.7

33.1

0

20

40

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80

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140

2000 2005 2010 2015 2020Year

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4 CLO Conference Notes 2020 Summer 2020

One panelist asserted that the current recession is unprecedented because of its cause. Social distancing has caused revenue to evaporate for whole industries (e.g., travel and hospitality). Interestingly, the healthcare sector has been hurt because elective services and procedures are not taking place. This recession is likely to cause market participants to reassess what diversification means. It also entails greater uncertainty than past recessions.

The current environment prompts a number of key questions: How long will the recession last and how deep will it be? How strong will the eventual recovery be and how long will it last? Will there be a resurgence of the COVID-19 pandemic? Will consumers ever go back to movie theaters? Will there be industries that completely disappear, and new ones that are created? Will there be new forms of employment and new forms of business funding?

Another panelist noted that several past recessions were caused by financial exuberance. They started in the financial sector and migrated to Main Street through contractions of credit availability and, ultimately, rising unemployment. The current recession needs a scientific/medical solution to end it. The COVID-19 pandemic is “a torpedo that hit below the waterline.”

One panelist observed that loan terms have gen-erally become more favorable for borrowers over the past several years. There is likely to be a rise in merger and acquisition activity. Another panelist asserted that investors should want CLO managers to have broad f lexibility in managing their CLOs and not be exces-sively constrained by deal structures (e.g., triggers and trading rules).

10:30 a.m.—Opening Keynote: The Longest US Economic Expansion Comes to an End (Mark Zandi, Moody’s Analytics Chief Economist)

The recession is over: Mark Zandi asserted that the recession is over. It will go down in history as being the shortest recession in the United States so far. It lasted just three months, March through May, while the average recession is about nine months. The shortest previous recession was six months. However, this recession also is likely to be the most severe. The peak to trough decline in real GDP probably will be in the range of 12% to 15%. By comparison, the peak-to-trough GDP decline associated with the 2008 financial crisis was about 4%.

The only comparable prior experience was the downturn of the early 1930s that ushered in the Great Depression.

Several factors support the view that the reces-sion is over. First, US lockdowns are winding down. Most counties across the country have reopened and the share of US GDP that remains shut down is in the low single digits. The economy went from significant job losses in March and April to job growth in May, with a positive outlook for June and beyond. While the US economy lost about 20 million jobs, many already have been restored and fully half are likely to be restored by Labor Day. The unemployment rate is now around 13.3% and it will probably settle around 10% or in the high single digits.

Additional reasons for optimism include both the f iscal and the monetary policies that have been very supportive. In particular, the Fed has been very effective in erecting a f irewall between the financial system and the mess in the real economy. In addition to pushing interest rates to nearly zero, the Fed eased capital and liquidity requirements for banks, and pro-vided further relief by buying huge amounts of bonds (quantitative easing). Before the onset of COVID-19, the Fed’s balance sheet was about $4 trillion. It recently has grown to about $7 trillion and will likely reach $10 trillion before it stabilizes. The Fed likely will buy a large portion of the Treasury debt issued to f inance fiscal stimulus.1

The Fed also has reactivated the credit and liquidity facilities it created following the 2008 financial crisis, further helping to stabilize and reassure financial mar-kets. Credit spreads widened sharply during the peak of the shutdown, but have substantially recovered thanks to the Fed’s actions. Apart from the Fed, Congress appro-priated $2.4 trillion, roughly 12% to 13% of US GDP, for fiscal stimulus. For comparison, fiscal stimulus fol-lowing the 2008 financial crisis came to about 10% of GDP. About $1.2 trillion of fiscal support already has been spent (Exhibit 4).

Most of the initial round of stimulus will be gone by Labor Day. Congress will have to pass another round of support to ensure the economy does not backtrack.

The effect of fiscal stimulus has been positive so far, more than offsetting lost wage income in 2020Q2

1 For comparison, US GDP was reported at $21.43 trillion for 2019. See Federal Reserve Economic Data, Federal Reserve Bank of St. Louis, data series GDPA, https://fred.stlouisfed.org/series/GDPA.

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The Journal of Structured Finance 5Summer 2020

and increasing disposable income by nearly $1 trillion. Available fiscal stimulus should continue to counterbal-ance lost wages through the third quarter, but beyond that it will fall short by more than $400 billion per quarter for the next year unless addition support is forth-coming. The good news (again) is that the recession has already passed.

The (weak) economic recovery: US economic output peaked in February 2020 at nearly $19.3 trillion (annual-ized, in 2012 constant dollars). Then it declined sharply in March and April, bottoming at about $16.7 trillion. Output stayed low in May (around $17 trillion) and is now starting to recover. It should stabilize at about $18 trillion by July and remain there through the remainder of the year (Exhibit 5).

Beyond Labor Day, the economy is likely to simply go sideways, without significant growth until the COVID-19 pandemic ends. That will happen when a vaccine or a treatment becomes widely available, so individuals can resume pre-crisis activities without jeop-ardizing their health. There is no way to know when that will happen or whether there will be a second wave of the coronavirus. Even if there is not political will to impose lockdowns, businesses might decide to curtail

their operations until COVID-19 is resolved. The high degree of uncertainly makes it unlikely that the economy will achieve meaningful growth before the pandemic is over. Of note, business and consumer sentiment are at very low levels.

There has been concern that the coronavirus pan-demic will trigger inf lation because of supply shortages and because of the Fed’s purchases of Treasury securi-ties. Although there have been price spikes for some products, they have not been enough to trigger general inf lation. Businesses have not been raising prices.

Another factor tempering the prospects for a rapid recovery is the wide geographical range of cur-rent recessionary conditions. This is not surprising, given the inherently global reach of a pandemic. In fact, current conditions are unusual in that the corona-virus has affected every major economy. In past inter-national recessions, at least one country was not strongly affected and served as an engine of global growth to revive others, as China did in the aftermath of the 2008 financial crisis. There is no country to play such a role in the current situation.

Indeed, a measure of caution is warranted. Both the optimism about the prospects for recovery and the

e x h i b i t 4 Fiscal Stimulus Response to COVID-19 (April 1 to June 10)

Source: Moody’s Analytics.

0.0

0.2

0.4

0.6

0.8

1.0

1.2

Apr 2020 May 2020 Jun 2020

$ Tr

illio

ns

Tax Filing DelayUnemp. Benefits

Aid to State & Local Gov’ts

Economic Impact Payments

Paycheck Protection ProgramPaycheck Protection Program

Economic Impact Payments

Aid to State & Local Gov’ts

g yUnemp. Benefits

Tax Filing Delay

Paycheck Protection ProgramEconomic Impact PaymentsAid to State and Local GovernmentsIncreased Unemployment Ins. BenefitsDelay of April 15 filing deadline to July 15Hospital ReliefAir Carrier Worker Support

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6 CLO Conference Notes 2020 Summer 2020

conclusion that the recession is really over hinge on the assumptions that 1) there will not be a second wave of coronavirus and 2) there will be another $1 trillion of fiscal support. Without the additional fiscal support, there likely will be a double-dip recession, with the next dip starting in 2020Q4 and continuing for a year. In any case, employment is not likely to recover to pre-pandemic levels for several years. Based on the political climate, though, it seems highly likely that additional fiscal stimulus will be forthcoming.

The fault line in non-financial corporate debt: The ratio of non-financial corporate debt to GDP has been rising in recent years, reaching nearly 90%. However, busi-nesses have been able to handle the debt because interest rates have been very low.

The recent recession is not an existential threat to the economy. The financial system is basically sound. After the COVID-19 episode passes (in 2021 or 2022), the economy probably will be able to bounce back.

It has been said that when something in the finan-cial system is growing like a weed, there is a good chance it is a weed. The volume of leverage loans in CLOs has grown rapidly, increasing 10.5% over the past year and 16.1% annually over the past three years (Exhibit 6)—and such rapid growth may be a cause for concern. While leveraged loans in CLOs are not necessarily weeds, their record of consistent double-digit growth deserves very close attention. Growth of

the economy has been at less than half the rate of CLO leverage-loan growth, and much of the recent growth of leveraged-loan volume in CLOs has been at weaker credit grades.

The total debt to high-yield borrowers is about $2.6 trillion to $2.7 trillion. There are about $1.4 trillion of leveraged loans, including roughly $650 billion to $700 billion in CLOs., and another $1.2 trillion to $1.3 trillion of other high yield corporate debt. That is roughly equal to the amount of subprime mortgage debt at the onset of the 2007 mortgage meltdown.

One point of concern is that the amount of Caa-rated loans in CLOs recently spiked from about 4% to more than 8%. In the 2008 financial crisis, the amount of Caa-rated loans spiked to 14%.

The industry concentrations of leveraged loans in CLOs are another area of concern. High-risk industries, including hotels, gaming/leisure, retail, automotive, energy, consumer durables, and transportation account for $101 billion, or 15.9%, of the leveraged loans in CLOs. Moderate-risk industries, including healthcare, pharmaceuticals, high tech, business services, consumer services, and capital equipment, account for $225 billion, or 36.8% of the leveraged loans in CLOs. About half the leveraged loans backing CLOs have some expo-sure to COVID -19. Even so, CLOs are well diversified across many industries, including ones that are not as threatened.

e x h i b i t 5 US Real GDP by Month (Jan 2019 to Dec 2020, annualized in constant 2012 dollars)

Source: Moody’s Analytics.

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The Journal of Structured Finance 7Summer 2020

Still, the increase in the level of corporate debt and its concentration in highly-leveraged companies (some of which are vulnerable to the pandemic) will produce business failures and bankruptcies. There already are key signs of stress, and many companies are late in paying their bills. The sectors with the highest proportion of late payments include hotels, movie theaters, performing arts, spectator sports, sightseeing, restaurants, museums, clothing stores, temporary help, clothing manufac-turing, and mining. Also, business bankruptcies have spiked recently. Monthly business bankruptcy filings have reached a level not seen since the 2008 financial crisis. This is a further indication that the economic recovery will be “a bit of a slog.”

Q&A: The baseline outlook is a sanguine one. Assuming that there is no second wave of coronavirus, and that anticipated fiscal stimulus is forthcoming, the recovery will have the shape of a swoosh rather than a “V.” But, if there is a second wave or if the economy does not get anticipated policy support, there will be a double-dip recession with a “W” shape. If that happens the stress on the financial system—including leveraged loans—will be significant. Then the scenario would be much darker: possibly a depression characterized by sev-eral years of double-digit unemployment.

A downside of the stimulus is that the country is taking on lots of debt. Before the 2008 financial crisis,

the ratio of US sovereign debt to GDP was around 40%. The borrowing associated with the 2008 financial crisis increased the ratio of US sovereign debt to GDP to around 80%. The recent stimulus has pushed the ratio past 100%—and it may go to 120%, the ratio’s all-time high following World War II.

At some point there will have to be fiscal austerity, possibly including tax increases, to lower the ratio of US sovereign debt to GDP. That could dampen any recovery and might herald higher interest rates. The other side of the pandemic is likely to include higher interest rates and higher inf lation. Indeed, low interest/inf lation rates were among the surprises of the recent episode of eco-nomic expansion. If they happen, higher interest rates could be very stressful for the leveraged-loan market.

A by-product of the COVID-19 environment is increasing market concentration in certain industries, such as retail. This could lead to reduced competition and higher prices that could fuel inf lation.

The stock market may be overvalued, but the Fed has given assurance that it will hold interest rates at low levels for the near term. That will likely sustain high equity valuations.

Individual income tax rates are likely to rise if Joe Biden is the next President. The tax breaks for high-income households will expire unless Congress renews them. Biden would be more open to trade, foreign

e x h i b i t 6 Credit Grades of Leveraged Loans in CLOs

Note: Does not include leveraged loans not rated by Moody’s.

Source: Moody’s Analytics.

0

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2019

2020

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Baa3 Ba1 Ba2 Ba3 B1B2 B3 Caa1 Caa2 Caa3

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B3

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8 CLO Conference Notes 2020 Summer 2020

investment, and immigration than President Trump is. Biden might take a tough line on China but he would not pursue a trade war. He probably would expand infrastructure activity and might reimpose regulatory controls on certain industries, such as banking and energy.

While covenant light (cov-lite) loan structures have contributed to the credit risk in the market, the prevalence of cov-lite loans has leveled off. About 25% of new leveraged loans over the past few months have had cov-lite features. While the market has adjusted, it makes the market more vulnerable. An offsetting factor is that there has been a good deal of f lexibility in nego-tiations between borrowers and lenders. A further rise in the proportion of cov-lite would be a negative credit development.

Recovery rates are likely to decline. A double-dip recession would be a real problem; it would trigger signif icantly higher default rates and lower recovery rates. It is almost a binary situation: we’ll either have a relatively benign recovery or a significantly adverse double-dip experience.

2:30 p.m.—Turning the Wheel: Assessing the State of the Leveraged Loan Market and Propelling Forward

One panelist explained that the key macro theme is the rising risk, as signaled by economic indicators. There was an extremely sharp contraction in 2020Q2. It was a very severe recession but strong rebounds are expected in 2020Q3 and again in 2020Q4. The events of March and April triggered not only fear of defaults but also a potential funding crisis. The Fed’s response largely addressed funding concerns and provided strong liquidity. CLOs have rallied recently on signs of economic stabilization. The panelist expects spreads on triple-A-rated CLO tranches to tighten to around 150 bps from around 170 bps last week, while spreads on triple-B-rated CLO tranches are expected to tighten to around 450 bps.

Another panelist noted that the leveraged loan market now is emerging from a precipitous decline and showing signs of recovery.

A third panelist pointed out that CLOs (and CLO managers) have been dealing with an environment in which a third of all corporate loans were downgraded or placed on negative credit watch. A particular challenge was that the bulk of the downgrades coincided with CLO quarterly determination dates. The better CLO

managers were able to deal with the downgrades under the pressure of impending determination dates, and to avoid breaching triggers. Weaker managers were not as effective, and some breached over-collateralization triggers, causing deferral of cash f lows to certain classes.

The fact that some CLOs have had negative net asset values (NAVs) recently is not particularly troubling because a negative NAV does not force a CLO to liqui-date. The structures do not depend on the market values of the underlying loans. In fact, an environment where loan prices are depressed creates opportunities for a CLO manager to seize bargains in buying new loans.

A manager or investor might inject capital into a CLO to cure a breach of an overcollateralization trigger, or to use a sidecar vehicle to provide a distressed bor-rower with rescue f inancing that might not be suit-able for funding through a CLO’s notes. Some deals allow CLO equity holders to inject capital into non-loan workout securities in ways that avoid running afoul of the Volcker rule.

Another panelist agreed with the remarks about the difficult timing of loan downgrades in relation to CLO quarterly determination dates. He emphasized that CLOs should be structured to allow participants to actively work out distressed loans to achieve maximum recoveries.

One panelist remarked that while there was a strong wave of rating downgrades, they have now slowed, and the market is showing signs of recovery. There is height-ened default risk, as ref lected in the high proportion of credits that have migrated into the triple-C range, but conditions are stabilizing. Maturities of outstanding loans are sufficiently distant that there is no impending risk from a “wall of maturities.”

Another panelist observed that technical condi-tions in the high-yield bond market are very strong, largely as a result of supportive actions by the Fed. There is much more financing activity. Some high-yield issuers are issuing secured bonds or bonds that rank pari passu with their term loans. He emphasized that the prospects for the market are not nearly as dire has many market participants envisioned in March and April. He argued that the incipient signs of recovery are cause for a reason-ably positive outlook.

One panelist observed that the average magnitude of downgrades on leveraged loans has been around 1½ rating notches.

Another panelist emphasized that CLOs have a great historical track record. No triple-A-rated CLO

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The Journal of Structured Finance 9Summer 2020

tranche has ever failed to return principal. Despite their high credit quality, wide yield spreads on triple-A-rated CLO tranches may be caused by 1) the fact that they have f loating interest rates and 2) uncertainty about the timing of repayment of principal (i.e., prepayment risk). The panelist expects spreads on triple-A-rated CLO tranches to continue to tighten. There is also good rating stability on triple-A-rated CLO tranches, though some with ratings at the double-A or single-A levels have been downgraded or placed on credit watch.

Another panelist noted that the arbitrage neces-sary to fuel new deals is not present while spreads on triple-A-rated CLO tranches are in the area of 170 bps. Tightening is necessary to restore the arbitrage—and it is likely to happen. Good performance during the second half of the year will prove the market’s naysayers wrong. The self-correcting mechanisms in the deals will work and quell the negative chatter about the sector.

One panelist added that investors can win either way: if the market rallies, or if the market’s naysayers are correct.

Another panelist asserted that the recent expe-rience provides a lesson in the diff iculty of spotting macro trends: the quick turnaround was completely unexpected. Another panelist observed that a key lesson of recent experience was the need for companies (bor-rowers) to maintain a focus on liquidity. A third panelist noted the value of a manager’s skills in picking good credits under stressful conditions and relying on its own analysis rather than giving credence to alarmist stories in the general media. The story is primarily about down-grades rather than defaults, which is what happened in the March-to-May recession.

4:00 p.m.—The Evolution of CLO Documentation Standards

One panelist asserted that CLOs are unlike other products on the structured finance landscape. The key difference is that CLO documents are heavily negotiated between debt and equity holders.

One panelist noted the “applicable margin reset” (AMR) feature is a new innovation in CLOs.2 Including

2 The AMR device has been in use for a number of years. For example, it was the subject of an SEC no-action letter in 2016. See SEC No-action letter re Sancus Capital Management LP (September 1, 2016), https://www.sec.gov/divisions/corpfin/cf-noaction/2016/sancus090116-reg-rr.htm.

an AMR feature increases the call risk to investors and reduces the value of a CLO’s notes. Another innova-tion is the “bankruptcy exchange” feature, which gives CLOs greater f lexibility to accept an asset in a workout situation that would not otherwise be eligible as a col-lateral obligation (e.g., equity or unrated loans).3

Another panelist added that some documents allow a CLO to purchase loans that would not other-wise qualify as collateral obligations. Some documents even allow unrated loans acquired in a workout situa-tion to receive overcollateralization credit. These kinds of innovations give CLOs more f lexibility to realize value in workout situations. The current Volcker rule prohibits covered funds (including CLOs) from acquiring equity interests except in workouts. How-ever, a change proposed in January would allow cov-ered funds to hold non-loan assets such as securities.4 That could help prevent CLOs getting “picked-off” by other creditors in workout situations. Another innova-tion is a “supplemental reserve account,” which allows CLOs to retain funds that are not necessary for pay-ments on notes to be used for workouts anticipated in upcoming periods.

A third panelist observed that, from an investor’s perspective, the impact of recent innovations depends on the seniority of the investor’s position in a CLO’s capital structure. The panelist asserted that credit risk exchange features are detrimental to investors because they allow CLO managers to evade protective trading rules. Likewise, capital contribution features allow a manger to game a CLO’s trigger tests. Springing bond buckets would allow for buying bonds (rather than loans) if the Volcker rule is amended to allow them, and they might be acceptable for investors. However, investors should not accept open-ended provisions that allow a manager to do anything permitted by future changes to the Volcker rule.

3 Provisions allowing greater f lexibility for exchange assets in workout situations have been used for more than a year (Pisha, Kim, and Hu 2018).

4 Office of the Comptroller of the Currency, Federal Reserve System, Federal Deposit Insurance Corporation Commodity Futures Trading Commission, and Securities and Exchange Commission, Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds, pro-posed rule, 85 Fed. Reg. 12120 (February 28, 2020) https://www .govinfo.gov/content/pkg/FR-2020-02-28/pdf/2020-02707.pdf.

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10 CLO Conference Notes 2020 Summer 2020

Investors should want the right to approve or dis-approve deal changes even if rating agencies agree to them.

One panelist asserted that hardwiring SOFR5 as the replacement for LIBOR is not an ideal solution. A better solution is to require approval of a CLO’s equity and the controlling debt class. Another approach is to defer converting the interest rate on a CLO’s notes to SOFR until the interest rates on the underlying loans also change (in order to minimize a basis mismatch).

Documents are allowing a broader range of amendments, subject to controlling class consent. This can allow amendment to documents without the consent of holders who are not being refinanced.

WEDNESDAY, JUNE 17, 2020

12:00 p.m.—CLO Master Class for Allocators

CLOs were notable in how well they weathered the 2008 f inancial crisis. CLO issuance volume was rising in the years immediately preceding the financial crisis, and came to account for a significant share of all non-mortgage securitization during that time. However, the volume of CLO issuance dropped dramatically in 2008 and remained severely depressed through 2011. It then started to recover and has been generally strong since (Exhibit 3). Although a number of CLO securi-ties experienced downgrades in the throes of the finan-cial crisis (mostly in 2009), there were very few actual defaults, and many of the downgraded ratings later rebounded. Overall, CLOs emerged from the financial crisis as a solid asset class. CLOs stood out from CDOs, which faired horribly through the financial crisis and are essentially a dead product.

A key differentiating factor between CLOs and CDOs is that CLO managers were able to reinvest pro-ceeds effectively while CDO managers were not.

Investors should focus on the key properties of CLO securities that shape their risk and value proposition:

5 SOFR, an acronym for secured overnight financing rate, is being promoted by various market participants as the replacement for LIBOR. SOFR is calculated daily by the Federal Reserve Bank of New York. See Federal Reserve Bank of New York, Secured Over-night Financing Rate Data, https://apps.newyorkfed.org/markets/autorates/SOFR.

• CLO securities are a type of structured security rather than a type of fundamental security. This means they do not depend on the fortunes of a single entity or enterprise for their cash f lows.

• CLO securities are non-recourse. Repayment of CLO notes depends entirely on the performance of the underlying portfolio of leveraged loans. There is no recourse to a deal’s manager or underwriter if the portfolio performs worse than expected.

• CLOs can be passive (static) or managed. In the former case, an investor’s risk relates to the initial selection of a transaction’s underlying portfolio and its correlation to the broad market (i.e., beta). In the latter, an investor’s risk relates to the CLO manager’s ability to create value by actively man-aging the portfolio (i.e., alpha).

Additionally, a CLO investor needs to understand who benefits from a CLO transaction (cui bono?). Inves-tors also should weigh their tolerance for uncertainty beyond the readily quantifiable elements of value and risk.

CLO investors take some fundamental credit risk, because the operations of leveraged-loan borrowers are the source of cash f lows that pay a CLO’s securities. However, the main risk to CLO investors is that the collateral value does not support the claims and that the yield is too low to properly support the risk taken.

Most of the collateral backing CLOs comprises broadly syndicated, f irst-lien, senior secured loans to speculative-grade borrowers. The loans have original maturities in the range of five to seven years, and interest rates indexed to three-month LIBOR. Exhibit 7 shows an example of a CLO’s capital structure:

Risks from the loans in a CLOs portfolio are miti-gated by a variety of factors including: 1) excess spread, 2) portfolio diversification, 3) subordination/overcollat-eralization, 4) interest coverage tests, 5) overcollateral-ization tests, and 5) active management of the portfolio.

Despite the fact that passive investment strategies are growing in popularity, active management is a ben-efit to CLOs because they do not have mark-to-market requirements, and skilled managers can exploit that f lex-ibility. In the future, it might be possible for algorithms to replace CLO managers, but that has not happened yet. Another criticism of active management is that although managers have different strategies and styles, they all

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The Journal of Structured Finance 11Summer 2020

sometimes miss key risks, such as the downturn in the energy sector or the onset of the coronavirus.

One panelist asserted that CLOs will avoid a CDO-style crisis because they have much lower model risk. Model risk for CLOs is arguably lower than for ABS, as overall, CLOs possess more defensive features. Addition-ally, they have a stronger track record of defaults than corporate bonds. However, CLO rating volatility has increased recently, driven by increasing downgrades and defaults of leveraged loans. On the other hand, prices of leveraged loans have rebounded somewhat from their lows of mid-March.

One panelist explained that the various features of CLO documentation may be more or less important to investors depending on the seniority of their posi-tion in a CLO’s capital structure. For example, a holder of junior notes is more likely to benefit from allowing greater f lexibility to the CLO’s manager.

One panelist cautioned that investors should always do their own credit analysis, including in the middle-market CLO sector. Investors should remain mindful of the conf licts of interest to which rating agencies are subject, which might undercut the accuracy of their ratings. Another panelist added that most investors in middle-market CLOs do their own credit analysis.

CLO equity investors focus on the initial arbitrage because there is little upside on the underlying assets;

the borrowers can readily refinance their loans. This is why the ability to refinance or reset the rate on a CLO’s notes is an important feature for CLO equity investors.

One panelist asserted that the CLO market likely will persist for at least another decade because it has become an essential part of the financial system, along-side commercial banks. There is room for improving risk management and increasing the use of algorithms. It may be appropriate to continue using the same mod-eling assumptions—including default rates—that were used before the onset of the COVID-19 episode.

1:00 p.m.—The New Normal: Evolution of the 2.0 CLO Manager

One panelist observed that the day-to-day activi-ties of CLO managers have changed recently to include 1) monitoring a high volume of rating downgrades, and 2) dealing with negative press about CLOs in the general media (such as Partnoy 2020).

Roughly a third of the loans underlying CLOs have been downgraded. The stress is concentrated in older deals. Between 20% and 25% of CLOs recently failed their overcollateralization tests. CLOs that got into trouble in the summer of 2019 were the first ones to fail their tests in 2020. Recent events revealed wide dispersion in manager performance.

e x h i b i t 7 Example of CLO Capital Structure

Pool of Loans, 100%

Class A (AAA), 65%

Class B (Aa), 10%

Class C (A), 7.5%Class D (BBB), 5%Class E (BB), 5%

Equity, 7.5%

Underlying Portfolio Securities

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12 CLO Conference Notes 2020 Summer 2020

There is a chain reaction in CLOs. Rating agen-cies start downgrading loans. Then weighted-average rating factors (WARFs) start to rise, which in turn causes CLOs to fail tests.

There are many challenges in trading a CLO port-folio during a downturn because of the need to work with applicable trading restrictions, downgrades, and depressed loan prices.

Investors are less trusting of managers that exploited structural loopholes in the last recession. Those managers may now have less f lexibility to be proactive because of additional restrictions in their newer deals.

Rating agencies have not changed their criteria, but they have added some stresses (note: this sounds like a contradiction). There is additional conservatism. It is not like 2009, when the rating agencies rewrote their criteria in response to the mortgage meltdown.

2:30 p.m.—LIBOR Transition in a Covid-19 World: Preparation Amidst the Chaos

• Is LIBOR really ending on December 31, 2021?• Understanding the options for SOFR (the leading

contender to replace LIBOR) • Challenges (and signs of progress) from CLO

investor and manager perspectives• Understanding the ARRC’s6 recommendations for

loans and CLOs

Whether or not LIBOR ends on December 31, 2021 depends on the banks that provide LIBOR quotes. Neither the Fed nor Britain’s Financial Conduct Authority actually controls whether LIBOR will per-sist beyond that date. Market participants should treat December 31, 2021 as the base case for when LIBOR will end.

When LIBOR ends there may be a variety of replacement rates, one of which will likely be SOFR. SOFR is currently the leading candidate to replace LIBOR for use by major f inancial institutions and multi-billion-dollar syndicated loans. SOFR is deter-mined from a blend of three overnight Treasury repo

6 The Alternative Reference Rates Committee (“ARRC”) is a private-sector working group that is promoting SOFR. The ARRC was convened by the Federal Reserve Board and the Federal Reserve Bank of New York in 2014 to address issues associated with LIBOR. See “Alternative Reference Rates Committee,” https://www.newyorkfed.org/arrc/index.html.

rates. However, it is only an overnight rate and not a term rate.

The market has not yet embraced any form of term (e.g., one-month, three-month, etc.) SOFR. There are several possibilities:

• forward-looking term SOFR• SOFR compounded in advance• SOFR compounded in arrears • simple SOFR in arrears

Forward-looking term SOFR and SOFR com-pounded in advance are most like LIBOR and offer the advantage that the rate for a loan would be known at the loan’s inception. However, forward-looking term SOFR might not exist by the time LIBOR ends, and SOFR compounded in advance creates asset-liability matching issues.

SOFR compounded in arrears and simple SOFR in arrears are less like LIBOR, and suffer from the dis-advantage that the actual interest rate on a loan is not known at the loan’s inception. Backtesting shows that SOFR compounded in arrears and simple SOFR in arrears produce very similar economics. However, the latter is relatively easy to implement while the former is difficult. Thus, simple SOFR in arrears may end up being the rate used in the leveraged-loans space.

SOFR may not be the right replacement bench-mark rate for all purposes. For example, AMERIBOR® is being proposed as potentially a better benchmark for some users, such as community banks, and some applica-tions, such as small business loans.7

Organizations already should be preparing for the end of LIBOR, preparing to amend documents for deals that reference LIBOR and for operational changes in trading and settlement systems.

CLO investors face several categories of issues. The toughest is how to deal with legacy deals. Many deals simply provide for using the last available LIBOR posting, which would convert a CLO’s notes to fixed-rate instruments. A legislative fix that would automati-cally convert legacy deals to a new benchmark is still a possibility, but the coronavirus situation has slowed the legislative initiative (Alternative Reference Rates

7 AMERIBOR® was developed by the American Financial Exchange. It is based on the actual unsecured borrowing costs of more than 1,000 American banks and f inancial institutions. See AMERIBOR® website, https://ameribor.net/background.

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The Journal of Structured Finance 13Summer 2020

Committee 2020). Although it is possible to amend legacy deals to address the LIBOR problem, issues remain about who would pay for the amendments. New deals also are being affected by LIBOR issues. There is no universal consensus for a “standard” template for switching to SOFR when LIBOR ends.

One panelist reemphasized that simple SOFR in arrears is arguably a better option than SOFR com-pounded in arrears, because the two are not meaning-fully different from an economic perspective and the former is easy to implement while the latter is very difficult. Additionally, hardwiring a simple-SOFR-in-arrears solution to the LIBOR problem makes sense despite the potential for a miniscule basis risk between simple SOFR in arrears and something else that ulti-mately may become the market standard.

Another panelist challenged the appropriateness of using SOFR as a benchmark rate for leveraged loans because SOFR is essential below the risk-free rate (i.e., it is based on overnight loans secured by Treasury securities). Also, the process of adapting CLOs to deal with the end of LIBOR is not a legitimate reason for shifting interest-rate basis risk from CLO equity holders to noteholders.

The International Swaps and Derivatives Associa-tion (ISDA) has decided to use SOFR compounded in arrears for derivative contracts.

The ARRC has published recommendations and timelines for business loans and CLOs to process the change from LIBOR to SOFR (Exhibit 8).

4:00 p.m.—Mezzanine Investor Roundtable: Getting Your Cash Back to Work!

Rapid fire questions: Are fundamentals improving or deteriorating? Panelists have differing views. One says fundamentals are improving. The second says funda-mentals are declining. The third says loan fundamentals are declining and that CLO fundamentals are uneven across deals.

Does the 5% bond bucket return in 2020? Two panelists say the 5% bond bucket will return in 2020 and one says “it depends.”

Where is the best value across the CLO capital stack right now? Panelists disagreed. One panelist says triple-A-rated classes offer the best value. The second says triple-B-rated classes offer the best value. The third says double-A-rated classes.

Are outstanding warehouses a problem for the CLO market right now? Two panelists say outstanding warehouses are not a problem. The third asserts that while outstanding warehouses are not a systemic risk, they may be a distraction from new deal f low.

Strength of fundamentals: One panelist asserted that the key strengths of CLOs are the post-2008 structural changes (including additional subordination) and the quality of collateral (especially the difference between loans and bonds). However, recoveries on recently defaulted loans have been low, possibly because of their covenant-lite features. Tranches at and above the double-B level should remain “robust” and should not suffer a significant amount of losses.

e x h i b i t 8 ARRC Best Practice Recommendations and Timelines

No more CLOs originated on LIBOR.

30 Sep 2020

30 Jun 2021

30 Jun 2020

31 Dec 2020

30 Sep 2021

6 months before LIBOR cessation

Business Loans

Start using hardwired fallback language for new loans (and refinancings).External vendors to have developed systems for handling all versions of SOFR.

No more loans originated on LIBOR.

If a party has discretion to choose a new rate, disclose the anticipated replacement rate.

CLOs

Hardwired fallback language for new CLOs (and refinancings).

External vendors to have developed systems for handling all versions of SOFR.

If a party has discretion to choose a new rate, disclose the anticipated replacement rate.

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14 CLO Conference Notes 2020 Summer 2020

Another panelist argued that loan fundamentals have deteriorated recently, and the deterioration is evi-dent across a wide range of measures. The leveraged loan default rate is 3.1% but it is likely to rise to the high single digits or low teens within a year. About 80% of deals are failing their weighted-average rating factor (WARF) tests and 32% are failing investment-grade overcollat-eralization (OC) tests. About 1,500 CLO tranches have been placed on negative credit watch. On the positive side, there has been stabilization of pricing. The pace of downgrades will slow, but the path of the economy over the next two quarters will be a strong determinant of the ultimate results. Double-B-rated tranches offer 6%-8% of credit enhancement, which means they can withstand a running default rate of 6%, while triple-B-rated tranches offer 11%-13% of credit enhancement, which means they can withstand a running default rate of 10%. Overall, CLOs remain an attractive asset class, but investors should tread carefully.

A third panelist noted that although most of the downgrades already may have happened, most loan defaults are yet to come. Loan defaults likely will be in the mid- to high-single digits over the next year, reaching a cumulative level of 15% over the next two or three years. Accordingly, most CLO tranches at and above the double-B credit grade should avoid suffering losses. However, there will be exceptions because some deals already have very high proportions of triple-C loans. The bottom 20% of CLOs are fundamentally

challenged. There is now more clarity about the eco-nomic sectors that are likely to experience the most stress as the COVID-19 episode plays out.

In a poll of the audience about the 12-month default rate for leveraged loans in 2020, 40% of respon-dents said they expect the rate to be in the range of 6% to 8% (Exhibit 9).

Pre-crisis vs. post-crisis CLOs: Post-crisis deals have higher credit support and better underlying assets than pre-financial crisis CLOs. The managers of post-crisis deals generally hold portions of their deals’ equity. Triple-C buckets are lower today than in pre-crisis CLOs, which allowed for up to 15%. Post crisis deals also are structurally stronger by being shorter. A common structure in post-crisis CLOs is a two-year non-call period and a four- to five-year reinvestment period. By contrast, pre-crisis CLOs often had three- to five-year non-call periods and five- to seven-year reinvestment periods.

CLO structures have evolved from so-called “CLO 1.0” (pre-financial crisis deals), to “CLO 2.0” in the post-crisis years (2010-2013), to “CLO 3.0” following the introduction of the Volcker rule (2014-2019), and finally to “CLO 4.0” following the onset of COVID-19. CLO 4.0 deals are often static, have three-year reinvest-ment periods, and have triple-A enhancement levels in the range of 40% to 42%. CLOs are not CDOs and have displayed much stronger historical performance. No tranches that were initially rated triple-A or double-A

e x h i b i t 9Audience Poll—What Will the 12-month Leveraged Loan Default Rate Be for 2020

12%

40%36%

12%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

<6% 6%–8% 8%–10% >10%

Prop

ortio

n of

Res

pons

es

Anticipated 12-month Leverage Loan Default Rate for 2020

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The Journal of Structured Finance 15Summer 2020

from the CLO 1.0 generation suffered losses. The loss rate for all rated CLO tranches was only 0.04%. On the other hand, some recent changes have been adverse. For example, 80% of the loan market has become cov-lite and the market has grown significantly. There has been a proliferation of B3-rated borrowers and of loan-only capital structures (i.e., borrowers that do not have subor-dinated debt). The performance of loans has the poten-tial to deteriorate, which could cause CLO mezzanine tranches to incur losses. Again, the next two calendar quarters will provide clarity.

Another panelist emphasized that 80% of the leveraged loan market is rated below double-B. Many CLOs are failing their WARF tests. One of the key ele-ments of the CLO market’s evolution is that transactions through the first half of the 2015 vintage are reaching their triple-C limits. Later transactions have lower pro-portions of triple-C-rated loans. Transaction vintage is a big factor, and it affects the industry concentrations in a deal’s portfolio. Above all, however, it’s always about collateral selection. A good manager can add value by trading out of troubled sectors and into those that are more resilient. CLOs provide strong credit protection. Loan defaults in the range of 9% to 10% per year for five to seven years would have to occur in order to break a CLO’s triple-B-rated tranches. The additional 4% credit support for triple-B-rated tranches in later CLO gen-erations is a strong benefit to investors and makes those tranches very safe.

The experience of stress in the energy sector was a lesson for the CLO sector that makes it stronger today. It takes a lot of loan losses for CLO triple-B tranches to suffer losses. It is not likely to happen.

Relative value: Valuations have increased significantly over the past few months. Mezzanine tranches of new-issue US CLOs are attractive because they have clean portfolios and higher subordination than older deals, and, thus, have lower downgrade risk. Valuations on new deals are in line with historical norms. European CLOs are an even better value than US CLOs because the under-lying loans have stronger fundamentals. CLO mezzanine tranches are a suitable product for expressing a broadly indexed view on the recovery of the general economy.

Another panelist said CLOs offer attractive carry and cheap dollar prices. Both US and European CLOs are attractive, but European CLOs are slightly more so. Upside potential is more pronounced in mezza-nine tranches, but exercising caution is still necessary.

Tail risk is everything right now. Some new deals are very attractive, including some CLOs backed by middle-market loans. However, some middle-market deals allow very large triple-C buckets, which may be a negative. Middle-market CLOs may be less liquid than those backed by broadly syndicated loans.

In a poll of the audience about the tightest level that spreads on triple-A-rated CLO tranches will reach in 2020, the greatest share of respondents expect the tightest level to be in the range of 130 bps to 150 bps. Asked about the tightest level for spreads on triple-B-rated CLO tranches in 2020, the greatest share of respondents expect the level to be in the range of 300 bps to 400 bps.

One panelist explained that the best managers were able to respond quickly to the onset of COVID-19 by trading out of sectors likely to be the most adversely affected and into those likely to be less affected. Some were able to build par through the trades.

One panelist noted that central banks have acted aggressively to contain volatility, and are likely to con-tinue with that approach. Another panelist added that there is likely to be some volatility in the CLO sector despite central bank interventions, but not to the same degree that there was in March.

Final thoughts: One panelist emphasized that mar-kets can move with staggering velocity. The market went from a liquidity squeeze to a potential default crisis that was averted by the Fed’s policy response. The Fed clearly learned from the financial crisis, and now central bankers seem willing to use their balance sheets to main-tain stability. A second panelist emphasized that investors should stay true to their strategies. Market “calamities” happen, but investors should not panic. Lessons are still being learned. We are still in the early innings. Weak-ening fundamentals are a backdrop. Stay true to your strategy. A third panelist noted that the COVID-19 epi-sode highlights the importance of liquidity management for investment returns. Stay liquid and rebalance often. The ability to move/react quickly is very important.

REFERENCES

Alternative Reference Rates Committee. 2020. “Proposed Legislative Solution to Minimize Legal Uncertainty and Adverse Economic Impact Associated with LIBOR Tran-sition.” March 6, 2020. https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC-Proposed-Legislative-Solution.pdf.

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16 CLO Conference Notes 2020 Summer 2020

Altman, E. Forthcoming. “COVID-19 and the Credit Cycle.” Credit Risk (version of May 19, 2020). https://s3.amazonaws .com/cdn.orrick.com/f iles/OrrickBlackSwansandFallen AngelsGlobalCreditMarketsandCreditRiskAnalysisPost COVID19June2020.pdf.

Kraemer, N., E. Gunter, J. Palmer, N. Richhariya, and L. Fernandes. 2020. “Default, Transition, and Recovery: 2019 Annual U.S. Corporate Default and Rating Transition Study.” S&P Global Research Report. June 17 2020.

Ou, S., J. Jiang, Y. Liu, K. Kanthan, A. Sheth, A. Van Praagh, D. Gates, K.-H. Chen, and K. He. 2020. “Annual Default Study: Defaults Will Edge Higher in 2020.” Moody’s research report. January 30, 2020.

Partnoy, F. 2020. “The Looming Bank Collapse.” Atlantic ( June/July 2020). https://www.theatlantic.com/magazine/archive/2020/07/coronavirus-banks-collapse/612247/.

Pisha, X., J. Kim, and J. Hu. 2018. “From Covenants to Cushions: Top 10 Credit Challenges CLOs Face Today.” Moody’s research report. December 13, 2018.

To order reprints of this article, please contact David Rowe at d.rowe@pageantmedia.com or 646-891-2157.

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