For the first time since the 2008 financial crisis, a collateralized loan obligation (CLO) has failed not only its junior but also its senior overcollateralization tests, according to BofA Securities researchers, reflecting the impact of record loan downgrades on the asset class.

Apex 2015-2, a CLO from Jefferies Finance priced in September 2015, is failing overcollateralization tests on the BB, BBB, A, and AA tranches. Overcollateralization tests are designed to ensure that the principal value of a CLO's loan portfolio exceeds the principal value of its issued debt. Broadly speaking, as the market value of a CLO portfolio declines, overcollateralization tests are triggered sequentially from the bottom of the capital stack, and redirect cashflows from junior debtholders to the AAA investor.

CLOs are special-purpose vehicles set up to hold and manage pools of leveraged loans. This segment accounts for roughly $700 billion of the $1.2 trillion in U.S. leveraged loans currently outstanding, making them by far the most dominant investor in the asset class. As such, CLOs have come under increasing scrutiny recently, especially as downgrades of leveraged loan issuers have piled up in 2020. CLOs generally have limits as to how much lower-rated (triple-C) debt they can hold.

While Apex 2015-2 is one of the first postcrisis CLOs to trigger these investor protections, it is hardly a storied deal. It was refinanced in May 2018, and Moody's even upgraded ratings on Apex 2015-2's C and D tranches in August 2019, saying that "the deal will benefit from higher spread and diversity levels compared to the levels during the last rating review."

Still, few managers had any form of preparation for the wave of coronavirus-related downgrades, with Apex 2015-2 seeing CCC concentrations increasing from 9% in March to 19% in April, according to BofA. However, the deal's reinvestment period ended in October 2019, locking in the portfolio and preventing the manager from trading out of downgraded names.

There are numerous knock-on effects of overcollateralization test failures. Roughly speaking, managers in reinvesting deals are cut off from investing cash in new transactions, and excess interest cash is redistributed from less-senior tranches to pay down the balance of the most-senior tranche. Overcollateralization tests can be cured if enough of the debt is paid down and the ratio of assets to debt comes back in line with indenture.

If anything, though, CLO managers' struggles with these tests are likely to get worse before they get better.

"We think further overcollateralization breaches are likely to occur as we continue to monitor deals that make their payment in April," wrote BofA researchers in their April 14 note. "With the estimated CCC share reaching 10.5%, we estimate 20–30% of deals could breach their junior OC tests. In many cases, managers may still have room to cure breaches by selling higher priced CCC loans (such as Riverbed Technology Inc. and BMC Software Inc.) and/or buying B-rated loans in the $80–90 price range."

Yet not all CLO managers believe that you can simply trade your way out of the problem.

"We don't think the rating agencies are done downgrading deals by any stretch of the imagination," said one CLO manager. "Maybe if you have 9% CCCs you can sell high-priced ones and buy above 80 or 85. But once you get to 10–11% in the CCC bucket, this becomes much harder to trade your way out of."

This article was written by Alexander Saeedy, who covers CLOs and leveraged finance for LCD.