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When something happens that could destabilize financial markets, the industry response is often just a reassurance that it is “not systemic.” This is a soothing and comforting line, but it is not very helpful.
Readers now interpret the phrase “irregular” to mean “will not cause a repeat of the global financial crisis.” Yes, this is a good thing, but many financial market problems can occur without becoming “systemic” in the same way that the global financial crisis did – especially because regulators have been working to reduce these risks for years. Remember that the Covid-19 pandemic caused a crisis of almost every other kind, but the major American banks did not collapse.
Anyway, this brings us to Altice France's recent decision not to use proceeds from asset sales to repay lenders, a decision that succeeded in angering almost every creditor and prompting rating companies to downgrade the company's loans to CCC.
A rating downgrade is not always exciting, but it matters a lot when €220 billion of the debt in question is held through collateralized loan obligations or collateralized loan obligations, according to Deutsche Bank estimates.
A quick refresher for readers who don't finance patients like us: Collateralized Loan Obligations are one of those fun investment vehicles that collect junk-rated loans, bundle them into a new security and usually put a AAA rating on the tranche with the most protection. These investors are supposed to be protected from losses by a cushion of lower-rated debt that takes losses first, along with a series of rules that enforce diversification and a minimum average quality of loans in the portfolio. (The quality measure uses ratings from companies like Fitch, Moody's, and Standard & Poor's, which certainly can't go wrong.)
In any case, because so many CLOs own Altice's debt — and partly because so much of its debt is there — many vehicles will have to respond. They can do this by selling low-rated loans, freezing reinvestment in order to raise cash, or direct liquidation at the request of shareholders.
Now, none of this is “systemic” in the sense that it would cause widespread US bank failures, job losses, and so on. But it will cause many headaches in the nearly trillion-dollar collateralized loan obligations (CLO) market. Over the past decade or so, collateralized loan obligations have become a direct source of supposedly safe return for life insurers, Japanese banks and other global investors.
However, now that the initial shock about Altice has worn off, Banks is starting to calm everyone down. From Barclays:
Accordingly, CLO investors would be wise to be wary of other potential CLO assets that may face the possibility of suffering a Caa/CCC downgrade, or even default. However, we do not see any single issuer posing a systemic risk to the CLO market, whether in EU CLOs or US CLOs.
Sure, that's reasonable.
But here's the problem: interest rates have risen a lot in the past two years, and it's not just one company that's feeling the squeeze in the leveraged loan market.
BNP Paribas gets a little closer in a recent note:
The downgrade of Altice France to the CCC category is evidence of high personal risk as loan borrowers have been facing high interest rates for an extended period of time. Although significant (through higher CCC exposures and structural implications), we see such an event as manageable for the CLO market. Diversification requirements and source concentration limits in collateralized loan obligation structures are key mitigating factors against personal risk.
Altice France alone is large enough to make a noticeable impact on the share of CLOs that violate its loan quality requirements:
The impact could spread globally if there are downgrades to Altice Financing, the credit that is more widely deployed in Europe and which has also faced questions about its creditworthiness, as described above.
So what does this mean for loan markets and collateralized loan obligations more broadly?
First, a downgrade could impose selling pressure not only on Altice France, but on all CCC-rated credits. In fact, the best-performing lower-rated loans may be sold first, in order to reduce realized losses for managers. From BNP Paribas:
On the loans side, we should expect some selling pressure on CCC names, as a result of more deals breaching their CCC tests (above 7.5%). Higher-priced CCC names could be candidates for sale so that any trading loss is minimized and the rest of the CCC basket will be treated equally once the CCC surplus is processed.
Collateralized loan obligations may be prohibited from reinvesting the proceeds of loans sold (or outstanding), to ensure there is enough cash on hand to repay investors in higher-rated tranches of those securities. The bank continues:
. . . Breach of the CCC tests may prevent further CLOs (after their reinvestment period) from being reinvested and effectively converting to a fully fixed state. This could lead to a marginal decline in demand from collateralized loan obligations, exacerbating the easing of pressure on leveraged loans. . .
For seasoned CLOs, breaching certain tests (e.g. CCC test, WARF test, OC test, etc.) can restrict further reinvestment activity, turning the deal into a fully fixed position. Following the Altice France downgrade, we estimate that approximately 25% of all Euro CDOs and approximately 32% of all US CDOs will be firm (as a result of failure of any “hard” test). Once trades are fixed, they tend to depreciate very quickly (about 25-40% annual repayment velocity based on recent observations). The acceleration in deleveraging speeds should benefit IG tranches through a credit boost leading to a rating upgrade. It can also trigger call events (liquidation or reset), which benefits discount bonds.
It also means that lower-rated CLO tranches could start trading at wider discounts to higher-rated tranches, especially if payments to equity holders are at risk. From BNB:
On the collateralized loan obligations side, we also expect further easing of pressure across tranches. We note that the capital structure is quite compressed at the moment. BB bonds have outperformed this year (they are about 80 basis points lower since the beginning of the year, see chart at bottom right) but remain vulnerable to sideways deterioration. Also, short-term CLO stocks, especially those with significant exposure to Altice, could be impacted by a decline in the stock's net asset value. Dispersion should also grow as deal collateral quality and performance are critical to investors.
Broader demand for leveraged loans could also be suppressed because more CLOs would be prevented from reinvesting cash, as noted above.
But hey, at least it's not regular!
