Why are CLOs pricing in a worse recession than Moody’s?

Investors have enjoyed very little respite this year, with every data release or piece of macro news causing a significant reaction from market participants.
 
One of the reliable trends though has been rising yields as risk assets have sold off. The effective yields on BB and B rated CLO bonds, for example, are now roughly 12-13% and 16-18% respectively (cash prices of 70-80 and 65-75). At that level the market is pricing in some sort of deep recession, though this is not what investment banks and rating agencies are actually forecasting. We have written before about the resilience of CLOs to deteriorating economic conditions , but let’s have another look at what credit performance could look like in a likely recessionary environment. 

 
Recently Moody’s released its global default study report, which is the rating agency’s outlook for global speculative grade corporates. While this isn’t a leveraged loan-specific outlook, leveraged loans (which comprise CLO collateral pools) do tend to follow the same pattern. In its baseline scenario Moody’s doesn’t forecast a recession. Instead it says a combination of high inflation, slowing growth and quantitative tightening by central banks will impact margins, but corporate liquidity will remain healthy due to most companies having locked in cheap funding in the last couple of years. Moody’s expects the 12-month European speculative corporate default rate to rise to 2.8% by the end of 2022, from 0.6% in June, and climb to 2.9% by May 2023 (it expects the global default rate to be 3.3% at this point).
 
Moody’s also runs through two pessimistic scenarios (and an optimistic scenario that we’ll ignore for now), both assuming a recession mainly driven by a worsening of the Russia-Ukraine conflict, persistent high inflation leading to tighter liquidity conditions, potential interruption of global oil supply and an increase in hospitalisations from COVID-19 with the subsequent impact on specific sectors. The first, the ‘Moderate Pessimistic Forecast’, sees default rates peaking at 5.9% in Europe, while the ‘Severe Pessimistic Forecast’ sees defaults reaching 9% in 2023 (that is versus 10.5% globally, and still well below the 13.5% peak during the global financial crisis). Industry wise in Europe Moody’s expects the sectors most impacted by the current environment to be Containers, Packaging & Glass, Hotels and Leisure & Tech.  
 
We think the Moody’s base case scenario is too rosy and we see their moderate forecast as more likely. Some of its ‘Moderate Pessimistic Forecast’ assumptions have already come true, and the study was probably based on data from May. Investment banks aren’t forecasting such high defaults, though as fixed income investors we do like to be on the conservative side.
 
We have therefore run a stress test on our single-B rated CLO holdings, assuming a spike in defaults to 6.5% for two years and an increase in CCCs as well. We gave some benefit to CLO managers’ ability to pick up loans at discounted prices during this period, and we excluded the deals which are already out of their reinvestment periods. We also ran the deals to maturity assuming they are never refinanced. The results of this analysis don’t surprise us. No security takes a principal loss to maturity, nor do any come close. Looking at today’s yields, it seems the CLO market is already pricing the Moody’s ‘Moderate Pessimistic Forecast’ as its base case, especially for the BB and B rated tranches.
 
So while we don’t think there is any need to reach for risk by going lower in the capital structure in the current environment, and we prefer BBB and BB bonds at the moment, for investors that are less sensitive to mark-to-market volatility and with long term investment horizons the potential risk-adjusted return offered by CLO bonds looks very appealing. In our view, it is CLO equity investors that should be concerned about defaults overshooting the Moody’s scenarios.