Analysis: Why a $1.5 trillion source of corporate financing is choking on higher rates

Bed Bath & Beyond

05/07/2023 06:10

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      CLO issuance down 41% in H1 vs same time last year 
    

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      Funding lifeline for junk-rated borrowers shrinking 
    

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      Investors demand higher premium
    

  
    By Naomi Rovnick and Chiara  Elisei
       LONDON, July 5 (Reuters) - A financial stream that
helped fund the world's riskiest companies and grew into a
market estimated at $1.5 trillion in the low interest rate years
is drying up, as aggressive rate hikes bring tougher borrowing
conditions and uncertainty.
    The pace of issuance of so-called collateralised loan
obligations (CLOs), which bundle loans of the weakest corporates
and repackage them as bonds, has stalled.    
    Specialist asset managers minted CLOs worth more than half a
trillion dollars in 2021, a year of heavy post-pandemic monetary
stimulus. Almost $69 billion worth were launched or refinanced
during the first half of this year, down 41% on the same period
in 2022, JP Morgan data shows.
        These vehicles, popular with hedge funds, insurers and
asset managers when borrowing costs are low and investors hunt
for yield, account for up to 60% of demand for the junk loans
rated single B or below, according to S&P Global Ratings. 
    But the market has sputtered just as companies whose debt is
considered a speculative investment face a mountain of
refinancing needs in coming years. 
     The sharpest rise in global interest rates in decades, an
anticipated global recession and fewer new CLOs to support junk
rated borrowers potentially create a toxic cocktail of corporate
distress. 
    "There haven't been large credit losses yet, but the
expectation is that bankruptcy rates [for corporate loans] will
go up," said Rob Shrekgast, a director at KopenTech, an
electronic trading and analytics platform for CLOs. 
    
  
       
    STORM CLOUDS 
    CLOs have grown into a market worth about $1.5 trillion,
KopenTech said. 
    Looking ahead, demand for the bonds issued by these vehicles
will "decline meaningfully," Bank of America (BofA) credit
strategist Neha Khoda noted, with potential for higher default
rates.
    While low now, debt defaults are rising. A restructuring at
French retailer Casino  CASP.PA  and the bankruptcy of U.S.
retailer Bed Bath & Beyond expose cracks in business models that
were previously insulated by abundant money supply and low
rates, analysts said. 
    S&P Global estimates that more than one in 25 U.S.
businesses and almost one in 25 European companies will default
by March 2024. 
    It's going to be a slow burn of rising distress, said Marta
Stojanova, leveraged finance director at S&P, of junk-rated
borrowers. 
    A "downside risk," she said, would be "the lack of funding
at an affordable level," for weak cashflow borrowers whose
existing loans are due for refinancing.  
    Weak cashflow companies, whose debt is considered junk, are
already paying the highest average interest rate on floating
rate debts in 13 years, S&P added.
    U.S. companies with speculative credit ratings, who dominate
global CLO loan pools, need to refinance around $354 billion of
debts by end-2024, then a further $813 billion in 2025 to 2026, 
S&P estimates. 
        
    OBSTACLES
    The CLO market has slowed because investors want higher
payouts as compensation for the risk of lending to weaker
borrowers. 
    "You've got more risk now and you want to be compensated for
that risk," said Aza Teeuwen, portfolio manager at fixed income
specialist asset manager TwentyFour. 
    When forming CLOs, the managers of these vehicles use the
loans as backing for bonds with varying prices and different
degrees of safety. Investors in the tranches considered safest
get the lowest returns, while those in the riskiest equity
portion receive excess cashflows after other investors are paid
out. 
    Now, fund managers who buy the highest rated tranches are
demanding higher yields. That has squeezed equity returns, and
without equity investors, CLOs cannot be put together. 
    S&P calculates that while CLO equity investors were able to
get a 15% annual return before 2022, deals priced now would
offer about 7%. 
    "You can no longer put together a (new) portfolio," said
Laila Kollmorgen, a managing director and CLO specialist at
PineBridge Investments.
    Kollmorgen said she was still finding good opportunities in
highly rated CLO tranches sold in the secondary market. 
    "We know there will be (loan) defaults at some stage," said
Teeuwen. "The (CLO) equity doesn't make enough money to justify
buying it." 
     CLOs have a reinvestment period of up to five years, after
which they cannot buy new loans. According to BoFA, 38% of CLOs
in existence will reach that expiry date by end-2023.
     That's another source of shrinking demand for junk debt,
and a factor BofA's Khoda defines as "a red-flag for issuers
with near-term maturities." 
    PineBridge's Kollmorgen sees uncertain times for high- risk
borrowers ahead. 
    "Increases in interest rates will have an impact on
companies and their balance sheets, its just simply a question
of when this actually comes through."

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The global CLO machine is slowing    https://tmsnrt.rs/3CX4AYC
US speculative grade debt due for refinancing    https://tmsnrt.rs/3NWxvCu
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 (Reporting by Naomi Rovnick and Chiara Elisei; Editing by Dhara
Ranasinghe and Alexandra Hudson)
 ((Naomi.Rovnick@thomsonreuters.com;))