Collateralized loan obligations are under stress, and institutional investors will be absorbing their pain in the downturn, according to JPMorgan Chase & Co.’s asset management unit.
Downgrades of risky corporate loans held by U.S. CLOs have accelerated since the first quarter as they have “significant” exposure to sectors sensitive to the coronavirus pandemic, David Lebovitz, J.P. Morgan Asset Management’s global market strategist, said Tuesday by phone. Eighteen percent of CLO assets are in vulnerable industries, including transportation, services, retail, gaming, lodging and leisure, a JPMorgan report shows.
“There is going to be some pain,” he said.
But in his view, the banks, which largely invest in the safest portion of the CLO structure, will hold up fine. “Who’s going to be hurt by this? It’s going to be asset managers. It’s going to be investors.”
Historically low interest rates before the downturn left investors doing anything they could “to get some yield in their portfolios,” according to Lebovitz. That demand led to “bad behavior” in credit markets, he said, explaining that underwriting standards for risky corporate loans deteriorated for years before the bull market ended.
Now that the tide has turned, insurers, hedge funds, pensions and structured credit funds face the potential for losses in the riskier pieces of CLOs, Lebovitz said. While default rates will continue to rise, he predicted they might not spike as high as during the financial crisis because of the U.S. Federal Reserve’s latest efforts to support markets.
“The problem will be on the recovery side,” Lebovitz said. Debt investors may “recoup a fraction of their investment given what we’ve seen over the course of the past decade.”
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For example, borrowers had been getting away with aggressive adjustments to earnings that made them appear more credit worthy, he said. That was during the good times. Now, J.P. Morgan Asset Management is expecting a 35 percent to 40 percent annualized decline in economic growth during the second quarter, according to Lebovitz. The next couple of quarters will be challenging for companies that got credit where it was not necessarily due, he said.
Still, Lebovitz questioned whether the Fed’s intervention was delaying or “outright avoiding the creative destruction process” needed “to get the leveraged finance world on more stable footing” coming out of the downturn.
“My bigger concern is not really the next 18 months – it’s that we paper over these cash flow problems with a variety of different types of lending,” he said. “Then we get to 2022, and we look around” to find many businesses are “zombies” that survived the downturn with a “cash infusion” when they should have “fallen by the wayside.”