Increasing economic uncertainty and concern about the impact of rising interest rates on non–investment grade borrowers have resulted in increased volatility in the leveraged loan market. We believe investment grade collateralized loan obligations (CLOs), which are securitized pools of leveraged loans, may offer an attractive way to access the loan space in the current environment.
Despite recent concerns about leveraged loans, we also believe there are several mitigating factors that investors can take comfort in. First, fundamentals remain strong and have continued to improve. Leverage among borrowers has continued to decline, and EBITDA and revenue growth were above consensus in the second quarter of 2022. Interest coverage ratios are at a three–year high, as revenue growth has outpaced interest expense. Further, default rates remain very low, standing at 1.36% over the past year (as of the end of August 2022), while average recovery rates were at their historical average of 62%.1
To be sure, there are increasing headwinds. Coverage ratios will likely decline, as higher policy rates begin to trickle through. Given the extremely low default rates recently, it is reasonable to expect an increase. J.P. Morgan is forecasting a 2.25% loan default rate in 2023, representing a material increase, but still lower than the historical average of 2.9% since 1992.2
Coverage Ratios at Three Year High
Sources: J.P. Morgan; Capital IQ.
CLOs are directly impacted by dynamics in the underlying loan portfolios, but benefit from structural risk protections. A combination of subordination, active management, collateral/coverage tests and the cashflow waterfall that characterize CLOs help to insulate investors, particularly those in investment grade rated tranches. As a result of these built–in risk protections, an extreme level of defaults is needed in an underlying loan portfolio to incur a loss of principal for investment grade CLO tranches if held to maturity.
Defaults, therefore, have been almost non–existent in the highest rated tranches. For example, AAA and AA rated tranches have never experienced a default loss. For BBB–rated CLO tranches (the lowest investment grade rating tier), it is estimated that 9–13% of a CLO’s loan portfolio needs to default for 5–7 consecutive years to lose the first dollar of principal.3 That is approximately 3–4 times the historical annual average, for multiple years—something that has never occurred.
Historical defaults in investment grade tranches have been extremely rare and were primarily experienced in CLOs issued prior to the financial crisis. Since then, subordination levels and portfolio guidelines have become even more conservative. An investment directly in a loan fund, on the other hand, directly exposes an investor’s capital to defaults. Based on J.P. Morgan’s 2023 default rate forecast and the average recovery rate of 62%, a loss of nearly 0.9% of principal would be expected in a leveraged loan strategy.
| Active Management | CLO managers analyze issuers and apply sector expertise to construct portfolios. Fees are generally linked to performance. |
| Credit Support | Subordinated tranches absorb losses first. |
| Covenants & Collateral Requirements | CLOs have features that are protective of debt tranches:
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| Excess Spread | Excess income vs. interest paid on debt tranches provides protection in case coverage tests are not met, which can be used to buy additional assets or pay down notes. |
Source: VanEck.
Although default risk is not the primary concern for investment grade CLOs, investors are exposed to both spread risk and downgrade risk. The level of single B–rated loans within the leveraged loan universe is an issue that has received some attention, particularly those which are only one downgrade from falling into the CCC category. This is of interest to CLO investors because most deals have a CCC exposure limit of 7.5%. If breached, cashflows get diverted from lower rated tranches to senior tranches. We believe the faster payoff of senior tranches in this scenario should help alleviate investment grade CLO investor concerns. Further, according to BofA Research, most CLOs are well below this limit, and it is worth noting that because CLOs are actively managed, managers have the ability to move into higher quality loans.
Historically, CLOs have performed relatively well in spread widening environments compared to leveraged loans, with an average outperformance of approximately 3.6% in the four periods in which credit spreads widened significantly since 2011.4 Longer term, CLOs have provided similar returns as leveraged loans over the past decade, with lower volatility, resulting in better risk–adjusted returns. Overall volatility and drawdown has been lower among investment grade CLO tranches overall compared to loans. However, lower rated investment grade tranches (A and BBB) have exhibited higher volatility and drawdown, which we believe necessitates an active approach that incorporates both bottom–up security selection based on extensive due diligence as well as top–down portfolio construction to add risk or de–risk based on market conditions.
VanEck has partnered with PineBridge Investments on the VanEck CLO ETF (CLOI), which provides access to investment grade floating–rate CLOs. CLOI benefits from PineBridge’s decades of CLO market experience, both as a CLO manager and CLO tranche investor, and deep leveraged finance expertise.
Originally published by VanEck on September 29, 2022.
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