CLOs have fueled the expansion of the leveraged loan market in recent years, driving coupons to record lows. Now companies they’ve lent to for years are finally offering juicy returns on new debt—but many CLOs are unable to invest.
A few weeks before the pandemic sparked a record-breaking stock market crash, the loan market was moving toward a record of its own. Tapping insatiable investor demand, companies such as Lamar Media repriced loan coupons to Libor+ 150bps, the tightest levels since before the 2008 crisis, sources said.
As more borrowers breached this level, CLO managers fretted about arbitrage being squeezed—but many put up with the low coupons because they were high quality credits they knew well. Fast forward two months, and they have a problem at the other end of the ratings spectrum.
After the coronavirus crash, cash-strapped companies like Golden Nugget, Everi and Surgery Center are offering enticing coupons on new loans. But many have been downgraded, meaning CLOs that are struggling with portfolio limits can’t buy in, four CLO managers told Debtwire.
In many cases, these investors are intimately familiar with the credits that are offering new debt, and confident they can bounce back from the downturn. But with downgrades coming thick and fast, participating in new deals could breach limits on how much debt they can hold with ratings in the CCC or Caa categories.
Those limits, typically set at 7.5% of a CLO’s portfolio, are especially relevant to managers that are breaching—or close to breaching—overcollateralization tests. Nearly 30 CLOs had failed OC tests as of last Friday, with two failing senior OC tests, according to Debtwire affiliate Creditflux.
Under this kind of pressure, buying into tantalizing new deals may not be an option, said three CLO managers. One such investor was unable to buy Golden Nugget’s recent incremental loan—which offered a roughly 15% yield—despite having held the company’s existing debt for years.
While the incremental loan was unrated, Golden Nugget’s corporate rating was just above the triple-C category at the time. Investing in the loan wasn’t prohibited outright, but the risk of downgrade made taking a position untenable, the investor said. Golden Nugget was later downgraded to Caa1/B-.
In March alone, S&P downgraded 114 leveraged loans, according to a recent update from S&P Global. Meanwhile, the number of companies Moody’s rates B3 negative or below reached 311 last week, its highest tally ever. Today, Moody’s put 20% of the CLO securities it rates on review for downgrade, citing increased risk in leveraged loans.
As corporate earnings increasingly reflect the impact of the pandemic, more leveraged loan downgrades are inevitable, sources said.
Last week, Surgery Center’s USD 120m incremental loan provided an example of how downgrades can impact demand among CLO managers who are breaching—or at risk of breaching—ratings-based portfolio limits.
At L+ 800bps, the borrower’s B2/B- rated loan offered juicy returns for investors willing to bet that clinic earnings will rebound after the crisis. But the company’s corporate rating is Caa1/B- and on review for for downgrade, discouraging some CLO managers from participating in the deal.
“The last thing we need is more CCC issues,” said an analyst at one such firm. “I might believe in Surgery Center coming back eventually. [But] the rating was a gating issue. I knew my portfolio manager would immediately reject it.”
Many such investors are also competing for allocations in new deals with opportunistic investors like hedge funds and private equity credit vehicles that can write big checks. This is a dramatic change for CLO managers, which for years have been the dominant buyers of loans.
Case in point, reverse inquiry from an investor outside gaming technology company Everi’s existing lender group drove the company’s USD 125m add-on loan, which priced last week at L+ 1050bps with a 98 OID, one of the sources said. Existing lenders, meanwhile, accepted a 25bps fee to waive leverage covenants until 2021.
Given the increased competition from investors with fewer portfolio limits, the prospect of smaller allocations is making it even harder for some CLO managers to participate in lower-rated new deals.
“If you're getting a small allocation it's not worth the headache” to invest in lower-rated deals, said another buysider of Surgery Center’s recent deal. “And I don't think many CLOs have the luxury of adding triple-C loans right now.”
Golden Nugget, Everi and Surgery Center did not respond to requests for comment. Neither did Jefferies, which arranged all three issuers' deals.