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'Assault' by biggest loan buyers could spell trouble in downturn

Bloomberg logoBloomberg 4/16/2018 Lisa Lee and Sally Bakewell

The biggest buyers of leveraged loans are weakening safeguards that limit how much risk they can take, amping up the potential pain for investors when the economy slows.

The buyers, known as collateralized loan obligations, are beginning to erode protections in their funds that, for example, prevent them from purchasing too many smaller loans that can be hard to sell later on, according to market participants. The CLOs are dialing down these limitations to boost profits for the money managers that put the complicated structures together.

The shifts mean that investments designed to be relatively safe, namely highly-rated bonds sold by CLOs and backed by loans, could end up being riskier than they appear. That has some echoes with structured securities sold during last decade’s housing bubble, which often ended up being stuffed with mortgages that were weaker than investors had expected, even if CLOs are still seen as being far safer than last decade’s collateralized debt obligations.

"We’ve really begun to see an assault on the CLO architecture in the last couple of months," said Peter Van Gelderen, managing director and co-head of structured credit at Guggenheim Investments. "Depending on the manager, there are varying degrees of the assault."

Record Sales

CLOs weathered the financial crisis relatively well as the downturn hurt mortgage borrowers more than companies. The investors that buy the securities demanded even more protections in the years after the meltdown. But in recent months, as interest rates have risen, demand for CLO bonds has increased, spurring the money managers who build the securities to weaken safeguards in the roughly $450 billion market.

Sales of CLOs were a first-quarter record of $37.5 billion, up from $17.4 billion in the same period last year, according to data compiled by Bloomberg. That in turn helped power $84 billion of new leveraged loan borrowing in the first quarter, Bloomberg data show.

CLOs’ greater appetite is just one factor making the leveraged loan market riskier for investors now. Companies have been borrowing more relative to their assets, which means that if a corporation fails and gets liquidated, the proceeds have to be paid out to more debt investors. And loans account for a higher percentage of junk-rated companies’ debt than they have historically, meaning there are fewer bond investors to help absorb losses when corporations go under.

Tweaked Documents

To be sure, while it’s becoming more common, the weakening of constraints is not widespread, Moody’s Investors Service said in a report this month. The less limiting constraints “can provide flexibility that managers can use to improve credit performance.” it said.

"There are always managers who are going to push for more investment flexibility," said John Fraser, head of Investcorp Credit Management U.S.

Early developments by managers of CLOs include tweaking definitions in bond documents, loosening protections, or removing safeguards in full. A CLO is set up when the manager buys loans that it securitizes into bonds. Those loans may generate more gains than investors had originally expected if, for example, a company’s credit profile improves.

Common in many deals is the ability to funnel gains made from building up the loan portfolio to equity holders, in what’s known as a “par flush". While that’s not new, lately it’s been used in “resets” of deals-- or where the deal’s life is extended and its investment parameters rejigged. That means gains that are getting flushed probably come from trading the collateral, rather than money left after purchasing the loans. Expanding the “par flush,” is becoming more common and could be negative for bondholders, said Stephen Anderberg, a credit analyst at S&P Global Ratings.

“In resets, it becomes more of an item the senior holders want to discuss because in these deals there’s no ramp-up period,” Anderberg said. “There may be an incentive for managers to trade the collateral pool to create excess par and then flush it out to equity holders.”

Par Flush

In January, a CLO by BlackRock Inc. called Magnetite VII included the par flush on a reset deal, according to people familiar with the matter. This provision allowed for the par flush to take place in the future provided certain conditions were met -- in this case, upon a future refinancing of all the debt.

BlackRock didn’t reply to requests for comment and representatives for Citigroup, which structured the transaction, declined to comment.

Increased par flushes are among the many terms that are becoming looser. For example, some CLOs have also gained more rights to buy a type of loan that won’t be first to get repaid in a bankruptcy. These “first lien, last out" loans have a lesser claim on company assets.

Looser Documents

Investors are sometimes willing to press for changes and have met with some success.

“Looser documentation has become a concerning issue in the last couple of months. We do push back and succeed,” said Laila Kollmorgen, managing director at PineBridge Investments. “You have to ask.”

In a CLO managed by Crestline Denali Capital, bondholders asked for limits on smaller loans that the money managers could buy, according to people familiar with the matter. The deal now includes a 10 percent cap on loans between $150 million and $200 million, a term that was in its other CLO offerings, one of the people said.

A representative for Crestline Denali Capital, based in Oak Brook, Illinois, declined to comment, as did a representative for the BNP Paribas SA, the bank arranging the deal.

‘Deemed Consent’

Another relatively new change is the notion of “deemed consent,” according to S&P CLO analyst Sean Malone. To make changes to CLO documents, the manager usually has to track down enough bondholders who agree to the shift. Under the deemed consent principle, if bondholders don’t respond to a manager notice of a change, they are deemed to have agreed.

While this provision makes sense in some cases where the burden of getting 100 percent approval is too high, the language opens the door for misuse, according to Vaibhav Kumar of Silverpeak Credit Partners.

“As the CLO documentation went to majority consent, the language was too loose and could be abused down the line by bad actors,” Kumar said.

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