Recent leveraged loan price volatility presents increased risks and opportunities for CLO managers, Fitch Ratings says. Managers in volatile markets are challenged to make credit calls that may significantly affect long-term performance for CLO investors. Market price volatility also contributes to the slowdown in new CLO creation.
Much of the price volatility relates to either the energy (oil & gas) or metals & mining (coal) sectors, which combined make up roughly 7% of the loan universe. Recent defaults have increased the trailing 12-month default rate to nearly 10.0% and 12.7% in the energy and metals & mining sectors, respectively, which Fitch expects to continue increasing through 2016. However, Fitch's overall leveraged loan default forecast sits significantly lower at 2.5%. Recent loan price trends are not necessarily indicative of Fitch's broader default expectations. Excluding these two sectors, we estimate the loan default rate for the rest of the loan market will be less than 1% in 2016.
To some extent, market price volatility may indicate that some junior CLO debt tranches have elevated default risk, but the senior notes will remain well protected. Market value over-collateralization (OC) to the junior note is a common performance metric used to differentiate manager performance, but this is a less relevant metric for senior noteholders.
The impact of loan price volatility varies across managers. Volatility creates a clear opportunity if the manager has cash to invest. However, the upside is less clear if a manager has to sell assets to take advantage of an opportunistic purchase. If the price volatility of some assets does not reflect increased default risk, then it can be a positive since the manager selecting these assets can immediately improve their OC tests as the asset is treated at par. However, if the 'CCC' asset limitation is at or close to its threshold, then the exceeding portion of the 'CCC' assets will be accounted for at their market value for the purposes of the OC test.
Price volatility also slows new CLO creation as portfolio prices on existing CLO warehouses are generally not favorable to the warehouse equity investor. If the portfolio is worth less than the acquisition price, then the warehouse equity investor is less likely to issue a CLO if the warehouse documentation allows them the flexibility to wait for a more stable issuance market. Price volatility also negatively affects the CLO creation process as new CLO equity investors may view the expected return profile on these investments as not commensurate with their risk profile.