July 25, 2019 / 8:48 PM / 25 days ago

CLO market prepares for downturn by pushing to swap defaulted assets

NEW YORK, July 25 (LPC) - Investors in US Collateralized Loan Obligation (CLOs) funds are increasingly pushing managers to include more flexibility in deal documents to address loan defaults as the market prepares for an economic downturn after years of growth following the credit crisis.

Managers are being asked to include the ability to swap out defaulted or deeply distressed assets with other similar loans that could offer better recoveries in the next downturn, according to sources. While not a new term - some investment firms have included a variation of the provision in earlier CLOs – the push by investors to include the optionality has increased, the sources said.

When a loan defaults, the CLO manager will typically need to mark the loan at the lower of either the market value or assumed agency recovery rate.

The US CLO market, the largest buyer of US leveraged loans, is preparing for an increase in defaults, which is expected to result in lower recoveries after years of low interest rates allowed companies to pile on debt with loose documents and few lender protections.

“If you have a recession, that CLO vintage will have higher defaults and managers will have to manage through it and some will do it better than others, but all will need the flexibility to do something about it,” said Olga Chernova, chief investment officer at Sancus Capital Management, which invests in CLOs.

PGIM included so-called purchased defaulted obligation or a swapped defaulted obligation language in its recent Dryden 68 CLO that allows the manager to purchase a different defaulted loan using all or a portion of the sale proceeds of another defaulted obligation, according to its deal offering document.

Some CLOs also allow for a similar swap with deeply discounted assets, the sources said. CLO documents will often limit how many assets may be swapped.

Moody’s Investors Services is seeing an uptick in these provisions in new CLOs, according to Leon Mogunov, an associate managing director at the ratings firm.

“Given the market environment, where we are in the cycle, we have observed that managers are looking for more flexibility with those provisions, (including) bankruptcy exchanges, deep-discount substitutions or credit risk exchanges,” he said.

Loan default rates are low as the majority of loans lack full covenant packages to be tripped, but Fitch Ratings says it expects the institutional leveraged loan default rate to finish 2020 at 2% with about US$33bn of defaulted volume, up from the forecasted 1.5% at the end of 2019.

As defaults increase, recoveries are expected to be much lower due to looser documents and more loan-only structures that lack bonds to help cushion some of the loss.

First-lien loan recoveries are forecast to be about 61%, down from the average historical recovery of 77%, according to Moody’s. Recoveries for second-lien loans are forecast to be just 14%, down from the average historical rate of 43%.

Allowing a CLO to swap defaulted assets “add just an additional element of flexibility for the manager because not all defaulted assets are the same,” said Jason Merrill, investment specialist at Penn Mutual Asset Management.

“Some (defaulted assets) may have higher recoveries and the manager thinks now that I have a bucket of defaulted assets, maybe I don’t need to reduce its size, but if I can swap into a better defaulted asset that could be a benefit.” (Reporting by Kristen Haunss. Editing by Michelle Sierra and Jon Methven)

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