Photographer: Gianluca Colla/Bloomberg

Investors Are Differentiating Between CLOs Even If Rating Agencies Aren't

A wide dispersion in loan prices.

Paging Tidjane Thiam.

The CEO of Credit Suisse AG just said he was blindsided by the bank's positions in illiquid debt products, including some $800 million in collateralized loan obligations (CLOs) consisting of sliced-and-diced loans made to junk-rated companies with fragile balance sheets. The products have had a tough time of late, plunging in price in the early part of the year.

A new note from Morgan Stanley analysts digs into just how tough a time the CLO market has had, arguing that "the long selloff journey of the U.S. leveraged loan market since [the third quarter of] 2014 has been accompanied by an increasing level of dispersion in loans within each rating cohort." In other words, investors have been differentiating between leveraged loans that carry the same credit rating, even if credit rating agencies aren't. 

You can see the dynamic in the chart, which shows the dispersion of loan prices by rating category. 

CLOchart

"Clearly, although all loans in the same rating cohort are deemed by rating agencies to have broadly comparable creditworthiness, the market has distinguished them to a larger extent," Morgan Stanley analysts led by Mia Qian said in their note.

They point out, for instance, that some 57 percent of loans rated B2—or five notches above default—by Moody's Investors Service Inc. are trading above 95. But almost a fifth of B2-rated loans are trading below 85—far lower than the average price of 91.6 for that rating group. Some are even trading closer to the 75.6 average of price of riskier CAA1-rated loans.

A previous study by the bank suggested that changes in credit ratings often lag behind changes in loan prices, suggesting that downgrades, if not necessarily further price declines, could yet be on the way.

"This empirical evidence demonstrates that the market usually will price in a higher chance of defaults/higher expected losses ahead of the actual downgrades," the analysts conclude.

Here's hoping Credit Suisse, which said it has now cut its CLO positions to $300 million, isn't left holding the tail of this particular market.

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