COVID-19’s impact on the CLO market
By Elen Callahan
Weather folklore says if March comes in like a lion, it will go out like a lamb. So much for folklore. COVID-19, social distancing, a declaration of a national emergency, and an oil price war all arrived in the U.S. in March. We will have to wait to determine the full toll they take on our economy and our population. In this article, we look at the potential impact of recent events on the CLO market.
The outbreak of COVID-19 has resulted in supply and demand shocks never before known to the world economy. As the number of confirmed cases in the U.S. continues to rise, the full impact of this outbreak on the U.S. economy remains uncertain. We look at possible impacts on U.S. industries as a result of widespread containment measures.
Global containment efforts continue to directly pressure global supply chains. U.S. companies in industries with integrated supply chains across multiple countries will continue to experience production stoppages and raw material shortages and this has resulted in unfinished goods and undelivered orders. Impacted sectors include electronics, auto manufacturers, auto suppliers, and consumer durables. Global shipping and cargo have had to pull back as demand for these services have come to a near standstill. Global containment has had a direct and immediate impact on air travel and almost all sectors that depend on the tourist trade (e.g. hotel/lodging, high-end retail, gaming, and cruise lines).
On a more local level, social distancing and shelter in place mandates have begun to weigh heavily on consumer demand as businesses, both large and small, close for extended periods of time as businesses scramble to safeguard their employees and to follow recently enacted prohibitions on the local or state level. This will place significant pressure on high-touch consumer discretionary industries such as restaurants, retail (non-food), leisure and entertainment. This pressure may be mitigated somewhat as companies can take their platforms on-line. For example, while Apple has closed its retail stores “until further notice”, some of the lost revenue may be picked up by its on-line platform. To this point, Amazon announced that they will be hiring 100,000 workers in order to meet rising delivery demand stemming from on-line orders.
CLOs with meaningful exposure to the impacted sectors will be most vulnerable to the COVID-19 outbreak. There are mitigants in place that address these risks. First and foremost, CLOs assets are diverse across industries and sectors. According to S&P, U.S. CLOs have exposure to about 1,500 issuers across more than 60 S&P-classified industries. As of March 11, 2020 S&P-rated U.S. CLOs have, on average, a 0.79% exposure to names that have experienced a negative rating action due, in part at least, to coronavirus concerns, with the highest exposure of any single U.S. CLO at 3.4%. Secondly, a CLO manager can improve a pool’s risk profile by actively managing the assets in a CLO pool. Bear in mind though, a manager’s ability to be effective will be challenged by liquidity, or lack thereof, in the underlying loan market. Thirdly, in the event of higher than expected defaults, CLOs have structural triggers that when hit will divert cash flow to protect senior tranches.
As the Fed has taken a “whatever it takes” approach to support consumers and businesses during these challenging times, government policies that benefit borrowers and lenders in the broad loan market, and by extension CLOs, can positively impact this market. One such program is the Fed’s Primary Dealer Credit Facility, or PDCF, which goes into effect on March 20. This backstop liquidity facility will allow primary dealers—banks and securities broker-dealers that trade U.S. government and other securities with market participants and the Federal Reserve Bank of New York—to borrow from the New York Fed on a collateralized basis in times of market stress. Triple-A rated CLOs, along with other securitized products, are eligible to be pledged as collateral under PDCF, easing potential liquidity concerns in this sector and supporting business lending during a period when businesses may need extra liquidity. SFA will continue to monitor this fast-evolving situation and work with our members to help individuals and businesses impacted by recent disruptive events. For additional resources, we encourage our readers to visit our members’ websites for their in-depth coverage of this unprecedented event: S&PGlobal, Moody’s, Fitch, KBRA, and DBRSMorningstar.