Below-average prevailing bond default rates may be misleading because of the increasing prevalence of covenant-lite credit, warned Nicolas Rousselet, head of hedge funds at Swiss asset manager Unigestion.
He pointed to a potential buildup of risk in the collateralised loan obligation (CLO) market, rather like that prior to the crisis in 2008.
The issuance of debt with fewer restrictive covenants leads to lower default rates, as breaches of covenants trigger defaults, he explained. As of mid-November this year, covenant-lite bonds accounted for 55% of outstanding bonds, up from 28% pre-crsis, and they now comprise 70% of current issuance in the US, said Rousselet.
The CLO default rate for 1994-2013 is 0% for AAA and AA tranches, 0.45% for A and 2.61% for B, according to S&P. The global corporate debt default rate for 1983-2013 is 0.09% for AAA-rated debt, 0.45% for AA and 24.09% for B, according to Moody’s.
While demand for debt investments is strong, oversight is lacking, said Rousselet, who urged caution when looking at historical default rates.
The European credit market had before the financial crisis been dominated by bank loans, with low volumes of high-yield issuance, he explained. Back then lenders added stringent covenants to loans to protect themselves.
But since the financial crisis, banks hold fewer loans on their own balance sheets. They are therefore less stringent about covenants because they are packaging and selling the loans as collaterised loan obligations (CLOs), he said.
Less stringent covenants mean many companies that should have defaulted have not done so because they could refinance through loans and bonds, Rousselet said.
“The CLO market didn’t suffer [rising default rates] in the global financial crisis because CLOs are controlled by the equity-holder,” he said. CLO equity holders had little reason to enforce a default and preferred to wait it out, even as holders of CLO debt tranches suffered losses.
In contrast, collateralised debt obligation (CDO) structures are controlled by the holders of the senior debt tranche, who are more likely than equity-holders to force a default. The CDO market collapsed in 2008-09 because senior debt tranche holders wanted to liquidate, said Rousselet.
He saw parallels between today’s CLO market and the run-up to the crisis, with investors taking on more risk than they realise because default rates are misleadingly low.
But Matt Natcharian, Babson Capital Management’s head of structured credit, is more sanguine.
The US CLO market has rebounded, but demand hasn’t kept up with supply, he said, and this disparity is creating attractive opportunities for investors. “I think they will persist for the rest of the year, at least,” added Natcharian.
Many Japanese and European banks that had participated in the CLO market in the run-up to the financial crisis have stayed on the sidelines.
Another reason for demand growing more slowly than supply is the Volcker rule under the US Dodd-Frank Act, which makes it harder for American banks to participate. In part, this is because the law treats most earlier-vintage senior CLO debt in the same way as it does equity in a hedge fund.
Securitisations that comprise 100% loans are excluded from the rule, but CLOs have historically comprised loans plus a 5% allocation to high-yield bonds. New CLO issuance is more commonly composed entirely of loans.
“There are a lot of good reasons why CLOs have done well and are very different from sub-prime mortgage CDOs,” Natcharian said. "But people still lump [CLOs] together with CDOs in general."
As a result, large institutional investors run into risk management issues when it comes to these instruments.
But Natcharian pointed to the big difference between the quality of the constituents of CLOs and CDOs, said.
That said, he admitted that CLOs are a less transparent market than other fixed income markets. It is a highly negotiated market, and the bid-ask spreads are wider even than high-yield bonds, for example."
Still, he saw US CLOs as a good alternative to corporate bonds, partly because they were floating-rate rather than fixed-rate products.
The yield on the loans in CLOs is about 500 basis points, Natcharian noted. “By investing in AAA-rated CLOs you’re getting 150-170 basis points out of that 500, yet you are shielded from the first third of net realised losses on the underlying collateral."