Even in recession, defaults will be lower than previous cycles
As inflation continues to outstay its welcome in the global economy, we have previously discussed the impact of rising input costs on corporates and how crucial pricing power can be in such a challenging environment. When it comes to collateralised loan obligations (CLOs), the potential impact of inflation and rising interest rates (or more broadly a recession) on the companies that feature in CLO pools is of course a key part of our analysis, and there are a couple of things we are keeping a close eye on at the moment.
First, an increase in the cost of debt for corporates due to tighter monetary policies is a potential threat for CLOs. If companies can’t pay the interest on their debt, that will likely impact the cashflows flowing into the CLO waterfall. Most leveraged loans in Europe are floating rate, however they usually have Euribor floors (between zero and 50bp) which keep the borrower’s cost of debt constant for longer. In the US, where rates aren’t negative and any such floor would not apply, corporate borrowers are facing a 2.5% potential increase in their cost of debt in the short term, based on the rate rises that are priced in by the market by the end of this year. One of the most important things we monitor closely is interest coverage ratios, since these indicate affordability; according to Moody’s, interest coverage ratios in Europe are currently between 2.1x and 5.3x for B3 to Ba3 rated companies, and a 200bp increase in rates would reduce them to 1.8x and 4.7x, so the impact is smaller than you would imagine.
Second, profitability could also come under pressure from rising input costs, especially for firms with limited pricing power. The sectors most impacted by inflation are obviously those that depend most heavily on consumer spending (gaming, consumer goods, retail, hotel and leisure) and on global supply chains (automotive, building materials, utilities, chemicals). Clearly, companies with lower interest coverage ratios and pressure on profitability will be at greater risk of default should economic conditions weaken.
However, we think CLO investors can take considerable comfort from a couple of other factors that should boost their resilience. First, exposure to those sectors that tend to be most impacted by inflation is relatively limited across European CLO pools, and a portion of the increased costs will be passed on to end customers, making the pressure on margins more bearable. Second, in the last couple of years a lot of companies have been able to refinance their debt to lock in cheap funding for the next five to 10 years; the weighted average maturity of the underlying loans in CLO pools is 4.75 years, which signals very little risk from debt maturities.
In our view, CLOs are in a favourable position when it comes to absorbing the impact of rising rates and inflation. However, we would expect corporate defaults to spike in a recessionary scenario, which is what the global markets seem to be pricing in right now. Investment banks and rating agencies are expecting the default rate for speculative grade companies to hit 1.5%-2.5% by the end of this year, before rising to 3-3.5% in 2023. For context, the long-term average default rate (since 2008) for leveraged loans is 3.2% according to S&P LCD, and the current rate is running at a historic low of 0.7%. In comparison those figures look relatively benign, though they could quickly change if growth and inflation expectations surprise to the downside. The current distress ratio is also currently very low at 0.8%, after reaching a peak of around 30% in March 2020 (via S&P LCD). On top of that, while the current loan default rate is 0.7%, the proportion of defaulted names in CLO pools is actually 0.2%, according to data from Intex, indicating the potential gains investors can make through active management and strong selection.
If we look at historical performance, defaults for CLO tranches have been extremely low with the peak in the last 20 years being just 0.82%, compared to a peak of 10% in the global speculative-grade corporate market, per S&P data. The majority of the CLO tranches affected in that period were BB and B rated, and all from deals originated pre-2008 with greater leverage than we typically see today.
If investors still have some reservations on the strength of CLO structures, modelling and stress tests in our view remain the best instrument to assess downside risk, and there is positive news here too. When the COVID-19 pandemic first hit in 2020, nobody could have forecasted what would ultimately become the biggest central bank intervention in history. We were initially expecting a deep recession, so at that time we re-modelled all our CLO holdings by stressing the underlying pools to default levels seen during the financial crisis in 2008. The outcome from that analysis was no credit concerns or principal losses on any of our holdings, even at the B level.
We think the risk of a recession in 2023 is fairly high at the moment, but we don’t expect default rates to be anything like the ones experienced in the past, and therefore we consider credit risk in European CLO debt to be limited.