Recession and CLOs
While CLOs performed well during the last crisis, and there is less dependence on short-term wholesale funding, the rise of loans with reduced investor protection and illiquidity are risk factors that could turn a run-of-the-mill recession into something worse.
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Disappointing economic data and the escalation of the US-China trade war have led to further inversions of the US treasury yield curve (figure 1). Therefore, the yield curve continues to point to a recession in the second half of next year. According to our model, the probability of a recession is now 79% by November 2020.
For now, we have a run-of-the-mill recession in our baseline forecast, expressed as modestly negative GDP growth in the third and fourth quarters of 2020. What could make the recession deeper and longer? Usually this occurs if a recession is accompanied by a financial crisis.
 The yield curve shows the interest rates for different maturities, for example from 1 month to 30 years. Under normal circumstances this curve is upward-sloping as investors require a higher compensation for lending for a longer time. However, at rare occasions the curve is downward-sloping (‘inverted’), which is often seen as a signal of a recession. For more details we refer to our yield curve Q&A (in Dutch).
Figure 1: Inversion of the US treasury yield curve
If we express the debt levels of households and nonfinancial businesses in terms of nominal GDP (figure 2) then it is clear that households continue to have more debt than businesses. This has been the case since the early 1990s. However, while households have been reducing their debt since the Great Recession, business debt has reached new heights relative to GDP. In fact, it is now almost as high as household debt to GDP.
Let’s take a closer look at business debt. The largest chunk of total business credit (USD 15,243bn) consists of corporate credit (USD 9,759bn). In turn, the largest segment of corporate credit is made up of corporate bonds and commercial paper (USD 6,240bn). These assets are held by insurance companies, mutual funds, pension funds, and other investors, both US and foreign. A smaller segment of corporate credit consists of bank lending (USD 1,520bn) in the form of C&I (commercial and industrial) loans. This includes drawn portions of credit lines and term loans.
Figure 2: Business debt to overtake household debt?
The smallest segment of corporate credit consists of leveraged loans (USD 1,090bn), which are made to businesses with speculative grade credit ratings who pay a substantial spread over the benchmark rate. They are usually arranged by a syndicate of banks. Leveraged loans are held either directly (mainly via mutual funds) or indirectly in CLOs (collateralized loan obligations). A CLO is essentially a package of loans to firms. In turn, these CLOs are held by mutual funds, insurance companies, banks and other investors, both US and foreign. However, there is a clear pattern: the safest, most senior (AAA) tranches are largely held by banks, while the riskier (mezzanine and equity) tranches are primarily held by asset managers, insurance companies, hedge funds, and structured credit funds. This means that in case of stress in leveraged loans, these are the investors that will be the first to feel the pain.
Although CLOs are part of the smallest segment of corporate credit, they are attracting most of the attention when people speculate about the next financial crisis. After all, CLOs sound very much like the CDOs (collateralized debt obligations) that packaged mortgages and played a crucial role in the last financial crisis. Last time, household debt was elevated and in particular mortgage debt caused a landslide when the housing market went downhill. Mortgage debt was securitized through CDOs. This time, business debt is elevated and leveraged loans are securitized through CLOs. Hence, they are causing some anxiety among policymakers and markets.
Collateralized loan obligations (CLOs) are special-purpose vehicles designed to manage pools of leveraged loans. The CLO is financed with several tranches of debt. The Class A tranche (typically rated AAA) ranks the most senior in the interest and payment streams, followed by the lower rated (mezzanine) tranches and an (unrated) equity tranche. CLOs are usually rated by two of the three ratings agencies and offer investors a range of choices with different credit risks and expected yields.
Figure 3: Example of Collateralized Loan Obligation (CLO)
On the positive side, the current CLO investors are less dependent on short-term wholesale funding than the leveraged structured investment vehicles that purchased CDOs during the last financial crisis. What’s more, CLOs did much better than CDOs during the previous crisis. However, the current structure of CLOs has not been tested under extreme stress yet. In particular, the rise of covenant-lite loans (i.e. reduced protection for investors) could cause problems in case of an economic downturn. Additionally, liquidity remains an issue. The market for CLOs is not very liquid even in normal times, let alone if financial stress rises. This could lead to larger losses for investors than they had anticipated. What’s more, the number of leveraged loan mutual funds and ETFs has risen substantially since the last financial crisis. Since these are much more liquid than the underlying leveraged loans market, this could add to downward price pressure of leveraged loans.
While CLOs performed better than CDOs during the last financial crisis, and there is less dependence on short-term wholesale funding, the rise of covenant-lite loans and illiquidity are risk factors of CLOs that could turn a run-of-the-mill recession into something worse.