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“Desperate” Hedge Fund Sold CLO At 80% Discount In Liquidity Panic

Courtesy of ZeroHedge View original post here.

A few weeks ago we reported that something "impossible" just happened in the world of structured credit: a CLO had just failed its AAA overcollateralization test, an event that was formerly considered impossible perhaps because it did not take place even during the depths of the global financial crisis in 2008/9.

And as increasingly more "impossible" events took place over the past two months, here is something else that should not have happened. As Bloomberg reports, "in one of the more desperate acts of the coronavirus-fueled credit crunch, a hedge fund last month sold about $100 million of European collateralized loan obligations for about a fifth of their face value." 

The hedge fund offloaded stakes in the lowest-rated tranches of European CLOs to a small group of banks including Bank of America said the anonymous Bloomberg sources, adding that while secondary market trading in CLO equity has been sparse in recent weeks mostly because one can driver a Hummer through the bid and ask, with U.S. deals seen anywhere between 20 to 80 cents on the dollar, depending on the quality of the collateral pool, market participants said.

The recent collapse in cash flows has triggered a record wave of rating agency downgrades with Moody's recently warning it may cut the ratings on $22 billion of U.S. CLOs – a fifth of all such bonds it grades. The ratings agency took action on 859 bonds from 358 CLOs that package leveraged loans into securities of varying degrees of risk and return. The step – which according to Bloomberg affects about 19% of Moody’s-rated CLOs that purchase broadly syndicated loans – comes as the underlying debt gets downgraded at a record pace.

As Bloomberg then pointed out, CLOs "are being downgraded at a pace so frenetic that it threatens to overwhelm safeguards that were put in place to ensure the securities’ financial strength."

As a result of the growing risk that increasingly more lower-rated tranches stop paying interest, hedge funds – which bought the structured debt using borrowed money – have found themselves in a liquidation panic since the Fed has so far refused to bail out CLOs, willing to take massive losses on holdings just to recover some principal. Ironically, CLOs, which package and sell leveraged loans into chunks of varying risk and return, became a darling of asset managers from pensions to hedge funds in recent years as record low interest rates and depressed bond yields encouraged investors to take greater risk. One such "investor" was Scaramucci's SkyBridge Capital whose fund of funds plunged 22% as a result of its billions in CLO investements.

As Bloomberg adds, some analysts expect as many as one in three U.S. CLOs may soon have to limit interest and principal payments to holders of the riskiest and highest-yielding part of the CLO structure – the equity portion. And, as we first reported on April 20, payouts are already at risk of being cut off for investment-grade tranches in about a dozen different transactions totaling a few billion dollars, including the formerly untouchable AAA tranche.

One thing that is certain is that the CLO firesales are only just starting as the asset class is battling not only a collapse in cash flows but a wave of downgrades to underlying corporate loans that threatens to overwhelm safeguards put in place to ensure the securities’ financial strength. One example: CLO debt rated BB fell to as low as 60 cents in late March, with the gauge rebounding in recent days to about 68 cents according to Palmer Square data.

But while it's only a matter of time before the lower tranches are now toast, keep an eye on the top of the stack: that's where the real pain for retirees and pensioners will soon be found.

 


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