What are Collateralised Loan Obligations?

  • The collateralised loan obligation (CLO) market grew significantly to over USD1tn on the back of record new issuances of over USD100bn in 1H21.
  • CLOs offer meaningful benefits, both on the upside, through notable yield pick-up (200bps for BBBs), and downside, with considerably lower defaults (2%, compared with the high-yield [HY] default rate of c.4%).
  • However, CLOs could experience some volatility in the coming months from the LIBOR transition, weakening covenants and volatile economic recovery.
  • Acuity Knowledge Partners has been providing end-to-end scalable and customised solutions to CLO asset managers for nearly 15 years. This, coupled with our proprietary LIBOR transition solution, helps asset managers with their overall investment decisions and risk assessment.
  • Weakening covenants: Moody’s loan covenant quality indicator for North America was 4.47 (on a scale of 5) compared with the five-year average of 4.00, indicating that the quality of covenants has weakened. Furthermore, the share of covenant-lite loans was 90% — the highest level ever.
  • Rating downgrade shock: Given the recent spate of upgrades, credit risk has now shifted to higher rating categories. S&P notes that B- loans accounted for 27% of the HY-rated universe as of 1H21 (compared with less than 5% as of 2Q20). This indicates rating migration from the CCC category as well as new B- credits. A wave of downgrades in 1H20 hit CLO managers, causing some portfolios to breach limits on low-rated holdings.
  • LIBOR transition: Record CLO issuance reflects, in part, a rush to close deals before LIBOR expiration at the end of 2021. Some CLO documents lack language covering the shift to a new benchmark rate, which could spark disruptions in 2022.

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Acuity Knowledge Partners

Acuity Knowledge Partners

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We write about financial industry trends, the impact of regulatory changes and opinions on industry inflection points. https://www.acuitykp.com/