Elena Rinaldi, portfolio assistant at TwentyFour Asset Management, examines how robust CLOs are through a recession

ABS is an asset class that lends itself well to detailed underwriting, from onsite due diligence through to cashflow and risk modelling. Specifically within the CLO sector, once TwentyFour Asset Management has reviewed the manager and the collateral, we focus on stress testing and sensitivity analysis. The hypothetical question "what if?" plays a fundamental role in assessing the resilience of the bonds we invest in to severe macro-economic shocks and general business cycles.

Every recession has a different driver; from the dot-com bubble in the early 2000s to the financial crisis 10 years ago, and there remain event-driven tail risk and numerous views on what might potentially cause the next recession. We can ask questions like: What if Brexit is a hard exit? What if Draghi raises rates earlier than expected and affordability becomes an issue? What if there is a hard landing in the Chinese economy?

Although we don't think that we are at the end of the cycle yet, we thought it would be useful to start the year with positive thinking and demonstrate the resilience of one of the largest and favoured sectors within ABS. Focusing on a recent CLO, let's consider how different scenarios could impact cashflows.

Structurally the CLO is a plain vanilla deal backed 100% by floating rate senior secured loans. This transaction has low exposure to both the oil & gas and retail sectors.

Current performance of the European leveraged loan market is very strong, as a result of strong fundamentals and low rates. Prepayment rates have been around 25%-40%, while the current outstanding default rate stands at 1.6% (in fact there are only a handful of CLOs outstanding with any defaults in the pool).

Away from a normal stress test (where we apply static default rates and loss severities in a large matrix) to see where a bond breaks, we are realistic that defaults are never static and come in waves. Consequently, we wanted to create a severe shock in the modelling and one we consider is the average of the dot-com and financial crisis recessions, where triple-C levels and defaults increased dramatically and recoveries on senior secured loans dropped to 50%-60% from the typical 70%-80%.

In our shock test we assumed that the economic shock will happen in two years' time, when default levels increase to 12% and over time recover to a normalised level - with significantly elevated triple-C levels, very low prepayment rates and 50% loss severities. Depending on the manager and the structure, we assumed that the manager has the ability to add value to the deal by buying at higher spreads and lower cash prices. We also tested 'multiples' of this scenario to gauge the sensitivity and be able to compare CLOs.

The outcome is very interesting for the selected CLO: there is no principal loss on the rated notes over the life of the deal. This means that even in a recessionary environment, an investor in the single-B rated note, for instance, will receive all their money back, together with all their coupons (which we see as being the best value in the credit markets at the moment).

Given the average single-B bond has around 7%-8% of credit subordination, that is an impressive result. This is because the deal is doing what it is supposed to: once overcollateralisation tests are breached, these tests show that on a risk-adjusted basis, there is enough credit support and all cashflows to the equity/junior investors will be diverted to deleverage the structure until cured by firstly repaying the triple-As.

In this specific scenario, the stress is so severe that the interest on the double-B and single-B tranches is deferred for 0.5-1.5 years, but fully repaid as the excess spread is enough to cover this. Nonetheless, the equity investor will suffer a significant loss. Despite this, triple-B and higher rated bonds are unaffected from a cashflow perspective, but markets will likely be very volatile in this scenario.

Equity investors will get paid until the OC test on the single-B class is breached; thereafter they don't receive any payment until 2022, when defaults start decreasing (as even in this scenario, there is some residual value left). The cumulative equity distribution is 36%.

This sample deal is only one of many in the market at the moment and the resilience to severe events will be also driven by the performance of each CLO manager. Contrary to popular belief, the pre-crisis vintages performed relatively well during the financial crisis, with low credit losses compared to high yield credit. Stricter regulation, cleaner portfolios, lower leverage, higher coverage cushions and prudent management should make this sector more resilient and an attractive investment.