Bloomberg/New York

The commodities bust is starting to pressure the biggest buyers of loans that help finance leveraged takeovers.
Collateralised loan obligations (CLOs), which bought more than half of the debt sold in the first six months of the year, backed away from the $800bn market in September as concerns about a deepening energy rout and a slowdown in China ravaged returns. Only $5.8bn of CLOs were created last month, according to data tracked by Bloomberg. That’s 34% below this year’s monthly average and the least since May.
The plunge in commodities is complicating an already-cloudy outlook for CLOs. They are grappling with new regulatory restrictions aimed at curbing risks in the leveraged-loan market, which boomed as investors searched for yield amid record-low rates. Sales of institutional loans reached a record $704.2bn in 2013, according to data compiled by Bloomberg.
That doesn’t bode well for companies from Belk to Concordia Healthcare Corp, which still need to syndicate $55bn of leveraged loans to fund acquisitions, according to data compiled by Bloomberg.
“It could take away an important source of funding for companies,” Morgan Stanley analyst Richard Hill said. “CLOs have become an even bigger buyer of leveraged loans this year.”
The funds, which repackage risky corporate loans into securities with ratings as high as AAA, bought 56.5% of new loans in the first half of 2015, Hill said. That’s up from 55% last year and 45% in 2013. Morgan Stanley estimates that CLOs have raised more than $78bn in the US this year, compared with a record $124bn in 2014.
The pullback in CLOs is already taking a toll on borrowers trying to raise loans.
Fullbeauty Brands is finding poor investor reception for $1.2bn of loans the retailer is raising to help finance its buyout by Apax Partners, according to two people with knowledge of the deal. Other borrowers caught up in the market tumult include ABB Optical Group, which shelved a $550mn loan package planned for a dividend payout, and Bain Capital- backed travel company Apple Leisure Group, which pulled a $460mn transaction, according to people with knowledge of the matter.
“There’s a lot more focus now on credit selection,” Morgan Stanley’s Hill said.
Loans lost 2.2% in the three months through September, the biggest quarterly decline since 2011, according to the Standard & Poor’s/LSTA US Leveraged Loan 100 index. At this rate loans are poised to lose 1% this year after gaining the same in 2014.
To make matters worse, CLO managers have been buying up lower-rated loans to make up for the yields being lost from new rules that prohibit them from buying speculative-grade bonds. The funds’ exposure to debt rated CCC has almost doubled to 4.3% from 2.3% two years ago, according to Barclays. A typical CLO portfolio permits just 7.5% of the loans to be rated CCC.
“Where else can you go to maintain yield?” said Anthony Bakshi, a credit strategist for Barclays in New York. “The natural thing is to go to lower rated and second-lien loans.”
For now, CLO managers have enough room to withstand future downgrades that would push that percentage of low-rated debt in their portfolios even higher, according to Barclays. But holders of the riskiest pieces of CLOs could face lower returns should ratings cuts accelerate, according to Citigroup analysts.
“That cushion looks healthy now,” but CLOs hold a 15% pool of loans with ratings just one level above the CCC tier, said Maggie Wang, Citigroup’s head of US CLO research. That “poses a threat as we come nearer the end of a benign cycle.”
An excess of CCC rated loans may cause managers to turn off cash payments to anywhere from 15% to half of the investments in those riskiest pieces, known as equity tranches, the analysts said in a September 30 report.
Unloading the debt would also be difficult, said Jonathan Insull, a New York-based money manager at Crescent Capital Group, which oversees $18bn of below-investment grade debt.
“The challenge is that those are the assets you want to sell - it’s potentially painful,” he said.