Some credit vehicles in the U.S. CLO market are struggling to move liquidity into the riskier markets they sought to capitalize upon in times of economic distress.
A debut manager in 2017, Ellington Management Group LLC raised cash for CLOs that carried higher-than-usual allotments for CCC rated debt, a level just a few notches above default. Ellington specifically said it could take advantage of other credit managers’ limits on owning lower-rated assets, which during a downturn would eventually force some to sell out of those positions, at a discount.
"Ellington does not want to pursue the same assets as those managers looking for collateral for a standard CLO," said Rob Kinderman, head of credit strategies at Ellington Management, in a February 2019 interview with Capital Structure. "Although our ultimate CLO structure may look a lot less efficient than others, it will allow us to retain flexibility to rotate and invest the portfolio."
But that scenario is not playing out exactly as expected in the age of COVID-19.
Today, Ellington’s vehicles are failing several benchmark tests designed to protect CLO investors, and are deferring interest payments to some junior investors, according to market sources. Additionally, the firm's CLOs are failing average rating tests, which limit a vehicle's ability to buy lower-rated credits, and have an average default rate of 12.21% across its three outstanding deals, according to JPMorgan researchers.
Ultimately, this means Ellington cannot take full advantage of the extreme selloff in lower-grade debt due to COVID-19, as it has already filled its distressed credit buckets by loading up on riskier assets in the lead-up to the credit crunch. Now, it faces the rapid amortization of its own deals.
Sources in the CLO market note that Ellington is still taking principal proceeds in some deals to invest in CCC assets that many investors have sold in the wake of COVID-19 volatility.
Ellington declined to comment for this story.
One cause for the situation at Ellington is that, despite holding a larger bucket for CCC assets, the Ellington deals’ investor protections, measured by overcollateralization (OC) tests, are significantly stricter than the rest of the market, according to deal documents reviewed by LCD.
That means that even though Ellington had more of an ability to invest in riskier assets than did other credit managers, as soon as they brushed up against the deal limits on holding CCC rated assets, they had substantially less room to maneuver, leading quickly to OC test failures.
Others in the CLO market say that Ellington’s cost of borrowing was so high that the manager was forced to bulk up on yieldy and riskier assets during a bull market to service its debts. That essentially left it with no way to hedge the market, leaving it with a raft of CCC assets when the downturn hit, many of which subsequently defaulted.
Several market sources say this is sufficient proof that the structure is imperfect, and probably will not be reincarnated in future cycles.
"Maybe in a more benign, normal cycle this might have worked," said one CLO manager. "The pace of downgrades due to COVID-19 has been difficult for anyone to stay in front of. But on the flip side, they immediately used the flex they had with the wider docs from day one. So this really was not a rainy day pitch."
Ellington’s deals number among roughly two dozen CLOs that were failing senior investor protection tests as of early May. Other managers include Pretium, First Eagle Private Credit, Marathon Asset Management, and ZAIS Group.
It is hardly apocalyptic that deals are failing these tests. They are largely designed to protect investors, and also limit risk-taking by CLO managers. The fact that these protections have kicked in is good for investors toward the top of a CLO's capital stack, and buttresses support in the asset class, sources say.
Collateralized loan obligations easily comprise the largest investor base in the $1.2 trillion U.S. leveraged loan market, accounting for roughly $700 billion in current outstandings, according to market estimates.
This story was written by Alexander Saeedy, who covers CLOs and leveraged finance for LCD.
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