As riskier, single-B rated debt continues to gather market share in the $1.18 trillion U.S. leveraged loan segment, regulators and high-profile market observers have become increasingly concerned that large-scale debt downgrades could post significant issues for collateralized loan obligations — by far the largest investors of leveraged loans — which have limits on how much triple-C paper they can hold.

This scrutiny on CLOs and downgrades has come into sharp focus of late amid sustained concerns about the U.S. and global economies, the health of an already aged credit cycle, and those mounting levels of riskier debt.

To that last point, the share of U.S. leveraged loans rated across the single-B range has grown significantly over the past few years, thanks to demand from yield-starved investors, brought about in part by rising interest rates in 2016-2018. Leveraged loans are floating-rate instruments, which tend to draw investor dollars in a rising-rate environment. As of September, some 56% of issues underlying the S&P/LSTA Leveraged Loan Index were rated either B+, B, or B–, up from 45% at the start of 2017. And the share of debt rated B- accounted for 13% of loan outstandings at the end of September, nearly double their share at the start of 2017.

Perhaps most notably, the share of outstanding loans rated triple-C was 7.5% at the end of September, the highest level since July 2013. That is up from 6.3% in June 2019.

The specter of leveraged loan downgrades to triple-C could pose a challenge to a CLO investor base that purchases nearly three-quarters of all U.S. leveraged loans currently being syndicated, and which holds 55% to 60% of all leveraged loans outstanding, according to LCD.

Indeed, the majority of CLOs have a 7.5% limit on portfolio holdings rated CCC+/Caa1 or below. The median share of CCC holdings within U.S. CLOs is currently 4.1%, according to Wells Fargo Securities. That share has ranged from 3% to 4% since 2016.

While the CCC share bears watching, the 7.5% limit is not necessarily a hard ceiling, as the market value of CCC paper in excess of 7.5% would then be deducted from a CLO's junior overcollateralization, or OC, test. Wells Fargo analysts, led by David Preston, estimate that those tests would not fail until CCC holdings hit 12%.

It is the failure of that test — which is triggered for a CLO only when a certain number of loans default, are sold at a loss, or the portfolio has an excess of CCC assets — that causes payments to the junior-most equity tranche of a CLO to be diverted, to instead pay down the senior-most tranches. Outside those factors, the junior OC test cannot be tripped from a decline in the market value of the underlying loans alone.

Downgrades picking up

Highlighting the worries about downgrades, some outstanding loans that are now running into trouble are being downgraded to that critical CCC mark. Already, rating agencies have downgraded more names this year than during the previous two.

Through Oct. 11, 282 issuers in the S&P/LSTA Index were downgraded, up from 244 in all of 2018 and 33 in 2017 (there are currently 1,460 issues in the Index). Putting these numbers into perspective, the ratio of downgrades to upgrades rose to 2.9x in the 12 months through September, the highest reading since November 2009, and up from 2.1x in 2018 and 1.6x in 2017, according to S&P Global. The last time upgrades outnumbered downgrades on a rolling 12-month basis was in October 2015, when the ratio stood at 0.9x.

In general, there has been a sharp deterioration in credit quality as 2019 has progressed, with the downgrade/upgrade ratio spiking to 4.9x in the third quarter (on a rolling three-month basis) from 2.6x in Q2'19, and from 2.3x in Q1'19.

Sectors seeing the most downgrades this year include business equipment and services (11% by count), healthcare (10%), electronics/electric (9%), oil & gas (7%), and non-food and drug retailers (7%). Seeing business equipment and services, healthcare, and electronics at the top of this list is not necessarily surprising, as these segments are also the biggest sectors in the overall leveraged loan market. The first two each account for about 10% of outstanding loans, while electronics accounts for 15%.

More telling than the absolute count of downgrades per sector is the change in sector mix year over year. Healthcare is among the most downgraded sectors, on a percentage change basis, with 27 downgrades by Oct. 11, compared to 12 in 2018, a 125% increase. At the same time, electronics/electric (a proxy for the tech sector) saw a 26% drop in downgrades, while downgrades in retail (other than food/drug), a sector that suffered a wave of defaults earlier in the credit cycle, dropped by 21%.

Looking at ratings distribution, of the 282 downgrades this year, 27% (75 facilities) moved to B–, with another 15% (43) moving to CCC+. This is a notable increase from last year when 20% of downgrades dipped to B– and 11% moved to CCC+.

Sell first, ask questions later

CLO managers, however, are not waiting for rating agencies to act. Instead, they're looking to get out in front of any earnings miss, especially as managers find liquidity disappearing quickly on a number of names.

The share of loans trading under 90 held by CLOs rose to 9.5% in October from about 8% in September and 6.5% in August, according to data from Wells Fargo. And 4% of loans in CLOs traded at less than 80 in October, compared to 3% in September and 2% in August. Most of the loans selling off were lower single-B rated loans, and not part of a widespread sell-off, as double-B rated loans remain well bid.

Most dramatically, such a sell-off was seen over the summer in the $782 million term loan B backing Deluxe Entertainment Services Group Inc., which started dropping from the mid-90s in July to 36–43 in early August, as a proposed spinoff and equity infusion did not go as planned. S&P Global Ratings shortly thereafter downgraded the issuer to CCC– from B–, while Moody's days later followed suit, downgrading the loan to Caa2 from B3.

The credit is held by a number of CLO managers, many of whom were unwilling to participate in additional financing for the company following the downgrade, as they were hesitant to double down on additional CCC exposure at this stage.

"You don't want to fill your CCC buckets now," a CLO manager said, adding that, "for every CCC loan today, there will probably be another three or four over the next few years."

As well, many CLO managers were prohibited from participating in a bridge financing, as a prominent insurance company/CLO investor does not like to invest with managers that allow them, sources said.

As a result, with the existing investors unable to provide sufficient financing, Deluxe Entertainment had to formally file for a prepackaged Chapter 11, obtaining a DIP loan instead. As of last week, the loan was trading at roughly five.

Mind the gap

So, as CLOs remain the largest buyers for leveraged loans, questions remain as to who will step in to buy certain credits when CLO managers do not want to, or when they are unable to for structural reasons.

Dealers, faced with more-limited balance sheets over the past few years, have also not been able to provide bids at those levels, in some cases providing only bids well behind current levels.

And while a significant amount of capital has been raised from funds targeting distressed strategies, such investors have sometimes expressed reluctance to get involved at lower levels, as the inability to have quarterly earnings calls or bring a borrower back to the negotiating table potentially leaves investors operating in the dark.

"Below 80, on down to around 60, you find yourself in no-man's land," said a CLO manager.

CLO managers who purchase new loans at those levels (without replacing another loan at that level, utilizing what's known as a discount obligation swap) may be less incentivized to do so, in part because they are required to mark the credits at their purchase price, for the purposes of the OC test, as opposed to those bought at 80 or above, which can be marked at par for the test.

Another potential issue: CLO managers purchasing lower-rated credits may bring scrutiny from their tranche investors.

"A manager must not only have a lot of conviction on an asset to buy it between 60–80 (and willingness to explain such conviction to CLO tranche investors) but also have room on their OC, CCC, WARF and other tests in case the asset subsequently gets downgraded before possibly trading higher," Barclays analysts wrote Oct. 11.

A WARF, or weighted average rating factor, measures the credit quality of a portfolio.

Enhanced CLOs

One of the ways those questions are being addressed is via a handful of CLO managers who have turned to issuing "enhanced CLOs," which allow for up to 50% of portfolios to hold debt rated CCC+ or below, a considerable difference from the standard 7.5%.

So far the only such deals have come from Z Capital Credit, Ellington Management, and HPS Loan Management, with others — such as Par-Four Investment Management — expected to join in. Investors will point out that timing is key for these CLOs. Given the much higher expected risk of the portfolio, tranche investors on these vehicles expect to be more highly compensated.

For example, HPS Loan Management on its enhanced Strata CLO I is having to pay 257.97 bps for its liabilities, compared to its more standard CLO months earlier, which was at 169.71 bps.

"You can't just hide in BB rated loans, waiting for the market to turn," a CLO manager said. "But that doesn't mean you need to buy up every triple-C out of the gates either."

This story was written by Andrew Park, who covers the U.S. CLO market for LCD.

LCD is an offering of S&P Global Market Intelligence. S&P Global Ratings is a separately managed division of S&P Global.

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