The Junk Debt Funds Threatening to Create an $88 Billion Logjam

  • A slump in CLO sales may cloud funding for leveraged buyouts
  • The funds purchased more than 61 percent of loans last year

With debt markets showing the first signs of life in weeks, Wall Street banks are trying to break a logjam that could leave them with big losses on $88 billion of risky corporate loans. They won’t get much help from one of their most reliable buyers.

Collateralized loan obligations, or bonds backed by pooled corporate debt, bought more than 61 percent of the leveraged loans sold last year. This year, CLOs are struggling to get off the ground having raised just $1.2 billion, according to data compiled by Bloomberg, down from $10 billion at the same time in 2015.

Investors have good reason to be leery of CLOs. As energy prices stay low and economic growth slows globally, many companies are having more trouble paying their obligations, gutting returns on the securities. Losses in some of the instruments are more than 11 times as they are in similarly-rated junk bonds.

The weakness in CLOs could gum up Wall Street’s debt-fueled mergers and acquisitions bonanza. Underwriters could be forced to either sit on the debt and mark down its value or sell it at steep discounts, either of which could crater their profits. Banks financing Dell Inc.’s $67 billion takeover of EMC Corp. are planning to raise $8 billion through a type of loan that’s typically marketed to investors such as CLOs, Bloomberg data show. Solera Holdings is hoping to sell at least $1.9 billion in a cross border loan this week to fund its purchase by Vista Equity Partners.

Dramatic Pullback

“There’s no question, the environment around lending into these transactions has pulled back dramatically," said Charles Ayres, chairman of Trilantic Capital Management LP, a mid-market private equity firm. "It’s not shut down completely, but lenders are far more conservative than they’ve been."

The rout in CLOs may prolong a slump in the loan market even as issuance of debt from less risky companies shows signs of recovery. Almost $19 billion of investment-grade bonds were sold Monday, and on Tuesday issuers including American International Group Inc. lined up to sell notes. 

But loans have lost 1.4 percent this year, after declining 2.8 percent in 2015 in their first downturn since 2008, according to the Standard & Poor’s/LSTA U.S. Leveraged Loan 100 index. CLOs were the biggest buyers of loans last year, according to S&P Capital IQ Leveraged Commentary & Data.

“Banks are having to pull in their horns a little bit,” said Jonathan Insull, a New York-based money manager at Crescent Capital Group LP, which oversees $19 billion of below-investment grade debt. “If you don’t see CLO formation, you have to think twice before doing a big underwrite.”

With the underlying debt performing poorly, Bank of America Corp., the largest underwriter of leveraged loans, last week cut its forecast for issuance of CLOs this year to about $45 billion from an earlier estimate of $70 billion. Investors’ demand for CLOs was already likely to fall, as new regulations aimed at curbing risk taking cut into the potential returns on the instruments.

“We would like to bring a new CLO to market but like everyone else, we are in a holding pattern,” said John Fraser, managing partner at the U.S. debt arm of London private-equity firm 3i Group Plc. “Capital market volatility in general and the CLO capital market volatility in particular have pushed investors to the sidelines, which suggests that this slow start is probably going to go on for some period of time.”

The credit quality of CLOs deteriorated in the fourth quarter due to weakness in the energy sector, Moody’s Investors Service said in a Feb. 16 report. The share of CLO assets that carry a negative outlook from the credit rater increased to 12.6 percent last quarter from 10.4 percent in the three months before. The percentage of loans held by CLOs that are rated in the CCC tier rose to 3.9 percent in January from about 3 percent the year before, according to a Feb. 5 report from Morgan Stanley.

The assets that CLOs hold have been deteriorating, taking a toll on returns and undermining demand for new funds.

CLO Losses

CLO bonds rated B lost 20.9 percent last month, Morgan Stanley said in its report. That compares with a 1.8 percent total decline in junk bonds with the same grade, according to Bank of America Merrill Lynch index data.

That subpar performance is adding to headwinds that CLO managers face from new risk-retention rules, which go into effect in December and require them to hold 5 percent of the debt they fund themselves with. The restriction is part of the 2010 Dodd-Frank Act enacted in response to the credit crisis that was fueled in part by securitized debt, particularly in the mortgage market. Almost a third of the 30 biggest CLO managers may be unable to comply with the rule resulting in fewer new funds, according to an industry-sponsored study conducted in 2013 by consulting firm Oliver Wyman.

“Risk retention is becoming an increasing consideration in the U.S. market,” said Fraser.“It’s now to the point where it would be very difficult for any managers to access the U.S. CLO market without demonstrating an ability to comply with risk retention.”

Bank of America attributes its decision to lower the forecast for CLO sales to market volatility.

“Our supply forecast revision is driven more by the capital markets’ volatility which plagued the markets in the second half of 2015 and unfortunately all of 2016 so far," said Collin Chan, an analyst at the bank.

Yields on top-rated CLO slices have risen to 2.4 percent this month from about 1.78 percent a year ago, according to data provider Markit Ltd.

“We’re in sort of a technical twilight zone or no-man’s land at the moment where you don’t have a ton of demand,” said Christopher Remington, an institutional portfolio manager at Eaton Vance Corp, which oversees $308 billion of assets. “It’s keeping prices low and yields high which by extension is keeping a lot of issuance from coming. There needs to be a catalyst to right the imbalance.”