The first half of 2021 has been a busy one for CLO land, with activity boosted by the unprecedented pace of refinancing and record levels of primary supply. But how have CLOs performed so far? We are going to leave the issue of spread performance aside for now and focus on fundamental performance. The CLO sector is driven heavily by technical factors and, due to high supply, continues to be very attractive. That, combined with a persistent improvement in metrics, has driven up demand.
As our investors know, we have reviewed our modelling and assumptions multiple times over last year and maintained a high level of due diligence and engagement with CLO managers. Back in November, when the 2nd wave of COVID started to spread across most countries and new restrictions came into force, the market was expecting defaults and CCC-rated assets to start underperforming in Q2/Q3 2021. Clearly, at the time, nobody foresaw the rapidity of the vaccine distribution, which, when combined with accommodative monetary and fiscal policy and continued financial aid for businesses, have supported the recovery.
How has the backdrop affected CLOs? According to BofA Global Research, the average WARF (a metric representing the average rating of the underlying loans in CLO pools) and level of CCC rated assets have improved materially and are now well below the peaks in 2Q20. The percentage of deals currently failing their WARF/CCC tests has dropped to 35%/19%, from the 95%/50% peaks in 2Q20 and 80%/40% at the end of 2020. The improving metrics gave managers more flexibility in trading and helped them clean up the portfolios. The average proportion of assets (leveraged loans and High Yield bonds) still trading below 80 is only 0.6% (as of June 21), down from 2.2% at YE20 and 21% from the peaks (source Intex & Markit). In addition, no deal breached any Collateralisation tests (from a peak of 3-4% in 2Q20) nor had any interest deferrals.
The average defaulted assets in European CLO pools remain low, around 0.5%, outperforming the ELLI (European leveraged loan index, 1.7%) thanks to positive selection and trading activity. In addition, almost 60% of deals have reported no default so far. Just a reminder for our readers that if you invest in a fund of BB-rated leveraged loans or HY bonds individually yielding ~3% and a portion of the fund or the bond defaults, you will recover only a portion of the principal invested while also depending on the recovery rate on that bond. On the other hand, you could invest in a BB-rated CLO tranche with 10% credit support (protection from losses) and get double the returns while taking less risk due to the numerous structural features that benefit CLO bondholders in a downside scenario.
Rating performance on the corporate side also pushed the metrics down in both HY and leveraged loan markets (primarily the collateral in CLO pools). At the same time, the three-month rolling upgrade rate in the ELLI increased for the first time since the COVID outbreak. Arguably, some broader sectors are still under pressure. Additionally, despite sponsors committing capital for large acquisitions and pursuing numerous dividend recapitalisations, thus driving loan supply to record volumes YTD, there is evidence of mixed asset quality with looser loan documentation, slowly increasing leverage and shallow levels of interest coverage.
We expect loan defaults to remain low, but the lack of covenants will likely impact recovery rates. In addition, there is still uncertainty around the sustainability of some businesses from sectors severely hit by the pandemic. That said, exposure in CLOs is relatively small, and it’s unlikely that fiscal support will drop away entirely if certain sectors are still under pressure.
Finally, based on these metrics, the picture seems rosy, and credit performance looks set to continue through the second half of the year should the main drivers of the recovery remain intact. However, it is worth highlighting that these are only average figures and, despite metric dispersion dropping significantly since 2020, we are still somehow seeing a greater credit quality distribution across deals. At 24, ongoing monitoring and deep due diligence are critical pillars of the investment process, allowing us to select the most suitable investment, especially at lower tranches in the capital structure.