As the adage goes, “History doesn't repeat itself, but often rhymes.” The recent sell-off in risk assets certainly proves there is some truth to the expression, displaying similar characteristics to 2015-16’s sell-off. In 2H 2015, the oil price meltdown and Chinese market turmoil caused a shift in investor sentiment to a risk-off environment. Leveraged loans also came under pressure as the sell-off in the credit market, which included Collateral Loan Obligations (CLOs), accounted for 60% of the U.S. leveraged loan market. However, it quickly rallied back by March of 2016 returning +9.78% for the full year, followed by another two years of robust growth. This revival of the CLO market raises the question: Will history continue to rhyme for the remainder of 2019?
The leveraged loan sell-offs in 2016 and 2018 were both driven by investor appetite and liquidity. Fund net outflows were approximately $11 billion in 2016 and $20 billion in 2018. The sectors most impacted also differed – in 2016, the energy sector experienced significant declines, while 2018 saw a broader sell-off that spanned all sectors and was driven by a looming recession, the U.S.-China trade war, Federal Reserve (Fed) policies, as well as other factors contributing to the elevated volatility. Despite a sharp rally in loan prices recently, I don’t expect the leveraged loan market to quickly rebound to its former glory.
Primary and secondary market activities are relatively quiet, leading to a standstill in CLO new issuance and a shrinking supply of CLO refinancings. Although there are some deals being marketed and in the pipeline for the near future, larger debt investors are moving slowly as deals are struggling to be completed. CLO managers and investors alike are waiting to see supply-demand rebalance and other uncertainties eliminated. The leveraged loan market has cooled since last year’s record of $125 billion in CLO new issuance, and has become more risky as downgrades continue to outpace upgrades and fewer protections. According to S&P Leveraged Commentary and Data (LCD), covenant-lite loans constitute about 79% of outstanding loans, up from 64% in early 2016. Therefore, recovery rates in the event of default are likely to be lower than 70% – the conventional rate that investors use for secured debts.
Currently, I believe leveraged loans and CLOs still deliver attractive attributes to buyers. Loans rank senior in a company’s capital structure compared to other types of debts and are secured by a company’s assets. According to the Loan Syndications and Trading Association, CLOs have been tested during recessions, and the senior tranches rated AAA/AA have yet to experience a loss on principal, securing a 0% default rate due to the features of the CLO structure. Moreover, the December sell-off gave CLO managers opportunities to buy clean and inexpensive loans. The senior tranche of a CLO has a low beta and less correlation to other asset classes, which may be a good fit for institutional investors in today’s volatile market.
Key Takeaway
Historically, the leveraged loan and CLO markets have lagged behind the equity and high-yield markets. I believe that as long as volatility remains calm, investors may begin to embrace CLOs. Investors, however, still need to keep an eye on future market volatility and the new Japanese Risk-Retention rule for banks, since they are frequent buyers for 75% of AAA and about one-third of all CLOs. I look for CLO opportunities with top-tier managers who have a long-term track record and construct clean collateral pools.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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