Thunder CLOuds Arrive: 6 CLOs Hit Triggers, Fail Tests

Over the past several months, we’ve kept a close eye on post-crisis CLOs or, CLO 2.0s, as they’re affectionately known. In the interest of not recounting the story in its entirety here (i.e. for the sake of brevity), here’s a list of posts those interested should review:

Issuance fell off a cliff in the wake of the crisis, but eventually rebounded, and by 2014, issuance was running at a $124 billion per year clip (comparable to auto loan-backed ABS annual supply, for reference). Supply slipped to around $95 billion last year and then, well, then it all fell apart.

The percentage of CLO assets carrying a negative ratings outlook jumped five-fold in just three months to 12.6% according to Moody’s and as Morgan Stanley has been keen to document, the market is literally falling apart.

As of the end of February, the median US CLO 2.0 equity NAV stood at -1.99 with the number of CLO 2.0 deals’ equity tranches currently having NAV below zero soaring by 30% from 348 to 453.

Over the same period, the underlying asset deterioration continued, we went on to note. By February 29, the median CCC assets in US CLO had reached 4.30% from 3.90% in January. Needless to say, this trend will only continue as the debt-laden US O&G space continues to spiral into oblivion. “Among the 180 loan issuers with price drops larger than 5 points in February, we see 32 issuers in Oil & Gas,” Morgan Stanley warns, before adding that “851 CLO transactions have exposure to these 180 issuers, with a median exposure of 7.07% in the CLO 2.0 space across 654 deals.”

To determine how it will all play out, we can take a look at history. Let’s go to Morgan Stanley one more time:

From late 2007, CLO equity investors suffered from a sharp decline in loan prices followed by a rapid increase of asset downgrades. The number of US CLOs failing junior OC triggers climbed and led to an increasing number of deals missing payments to equity tranches. The proportion of deals cutting off payments to equity tranches peaked in 2Q 2009, right after the bottoming of loan prices and the peak of loan downgrades in 1Q 2009.

Got it. So the credits in the collateral pool suddenly all sour at once, the triggers are hit, and the subordinated tranches are a really bad place to be. Take a look at the red line here:

That’s missed payments to the equity tranches when the market blew up in the wake of the crisis (i.e. that’s CLO 1.0s). The question is how long before that dynamic plays out in 2.0s. As we noted late last month, Moody’s and S&P have delivered their first downgrades of post-crisis CLOs. Here’s a look at the tranches affected by Moody’s decision:

Now, we learn that Silver Spring and Silvermore, along with four other CLO 2.0s are failing their interest diversion tests. That is, they’ve hit their triggers and payments to the equity tranches are in jeopardy pending how things look next month. Here’s Deutsche Bank:

Looking at interest diversion tests, there hasn’t been any diversion of cash interest payments to the equity tranche of post-crisis CLOs so far, but it will come down to the status of these tests for the payment dates in April. Right now there are six CLOs failing their interest diversion tests. One of those, Jamestown IV, is just barely failing the test. Three other deals have coverage right above their respective interest diversion triggers, see Figure 20.

Apart from these deals most other CLOs still have a good buffer before tripping interest diversion tests. Out of the 589 post-crisis broadly syndicated CLOs that have interest diversion tests and are still in their reinvestment period we find twenty deals (including the three mentioned in Figure 20) that have a buffer of one point or less before tripping the test. Other deals have a larger buffer. Figure 21 shows how well the 589 deals are covered, in terms of passing the interest diversion test. We show the data normalized by the initial collateral balance. The graph shows each deals collateral test par value relative to the initial collateral balance plotted against their interest diversion trigger, normalized the same way. Finally, the red line shows where the trigger lies, so the distance from the red line to the blue dot representing each line represents the interest diversion test buffer.

Despite Deutsche Bank’s attempt to strike an upbeat tone, what the above means is that the market is beginning to crack and if you get anything out of Morgan Stanley’s recent series of updates, it should be that it won’t be long before there’s (much) more trouble in OC trigger land.

Meanwhile, issuance was actually up this month, but we wouldn’t get too excited about the prospects for the leveraged loan market – supply was still some five times lower than last March.

So keep the faith we suppose and remember: Citi can’t imagine how CLO mezz could possibly be any more attractive.

Oh, and don’t forget that next month banks will reevaluate credit lines on RBL for the beleaguered O&G sector. We’ll leave it to readers to determine for themselves what that means for CLO 2.0s, but we will give you a hint. Match up the following table with the “Deal Name” column in Figure 20 shown above.