When something happens that could be destabilising for financial markets, the response from the industry is often just reassurance that it’s “not systemic.” That’s a soothing and convenient line, but it isn’t very helpful.
Readers now interpret “not systemic” to mean “won’t cause a repeat of the global financial crisis”. And yes, that’s a good thing, but a lot of financial-market problems can happen without becoming “systemic” in the same way as the GFC — especially because regulators have been working to limit that risk for years. Remember, the Covid-19 pandemic caused a crisis of almost every other kind, but big US banks didn’t collapse.
Anyway, this brings us to Altice France’s recent decision not to use proceeds from asset sales to pay back lenders , which managed to piss off almost every single creditor and prompt ratings firms to downgrade the company’s loans to CCC.
Downgrades aren’t always exciting, but they matter when billions of dollars of its debt* are held by collateralised loan obligations or CLOs.
A quick refresher for readers who aren’t finance sickos like us: Collateralised loan obligations are one of those fun investment vehicles that bundles junk-rated loans, packages them into a new security and usually slaps a AAA rating on the tranche with the most protection. Those investors are supposed to be shielded from losses by a cushion of lower-rated debt that takes losses first, along with a series of rules that enforce diversification and a minimum average quality for the loans in the portfolio. (The quality measurement uses ratings from firms like Fitch, Moody’s and S&P, which surely could never go wrong .)
Anyway, because so many CLOs own Altice debt — and partly because there’s so much of its debt out there — many of the vehicles will have to respond. They could do so by selling low-rated loans, freezing reinvestment to build up cash, or straight-out liquidations at equityholders’ prompting.
Now, none of this is “systemic” in the sense that it would cause widespread US bank meltdowns, job losses, etc. It will cause many headaches in the nearly $1tn CLO market , however. Over the past decade or so, CLOs have become a go-to source of supposedly safe yield for life insurers , Japanese banks and other global investors.
Anyway, now that the initial shock about Altice has worn off, the banks are out calming everybody down. From Barclays:
Accordingly, it is only prudent that CLO investors are wary of other potential CLO assets which could face the possibility of suffering Caa/CCC downgrades, or even defaults. However, we do not see any single issuer posing a systemic risk to the CLO market, in EU CLOs or in US BSL CLOs.
Sure, that’s reasonable.
But here’s the catch: Interest rates have climbed quite a lot in the past couple of years, and it’s not just one company that’s feeling stress in the leveraged loan market.
BNP Paribas gets a little closer in a recent note:
The downgrade of Altice France to CCC category is evidence of rising idiosyncratic risks as loan borrowers have been facing high rates for a prolonged period of time. Although material (through the rise in CCC exposures and structural implications), we view such an event as manageable for the CLO market. Diversification requirements and issuer concentration limits in CLO structures are key mitigants against idiosyncratic risks.
And on its own, Altice France is big enough to have a noticeable impact on the share of CLOs that are in breach of their loan-quality requirements:
The effect could spread globally if there are downgrades of Altice Financing, a credit that’s more widely held in Europe and has also faced questions about its creditworthiness, as shown above.
So what does this mean for the broader loan and CLO markets?
First, the downgrades could put selling pressure on not just Altice France, but all CCC-rated credits. In fact, the best-performing low-rated loans may get sold first, in order to minimise realised losses to managers. From BNP Paribas:
On the loan side, we should expect some selling pressures on CCC names, as a result of more deals breaching their CCC tests (above 7.5% limit). The highest priced CCC names could be sale candidates so that any trading loss would be minimised and the rest of the CCC basket would be treated at par once the CCC excess is cured.
CLOs may be prevented from reinvesting proceeds of sold (or matured) loans, to ensure there’s enough cash on hand to pay back investors in the top-rated tranches of those securities. The bank continues:
. . . the breach of CCC tests may lead to more CLOs (after their Reinvestment Period) being restricted from reinvesting and effectively turning fully static. This could result in a marginal drop on demand from CLOs, exacerbating decompression for Leveraged loans . . .
For seasoned CLOs, the breach of some tests (such as CCC test, WARF test, OC test, etc…) could restrict further reinvestment activity, turning the deal into fully static mode. Following Altice France’s downgrade, we estimate that ~25% of all seasoned Euro CLOs and ~32% of all seasoned US CLOs would be static (as the result of failing any ‘hard’ test). Once static, deals tend to amortise quite fast (~25-40% annual repayment speed based on recent observations). The acceleration in deleveraging speeds should benefit IG tranches through credit enhancement build up and leading to rating upgrades. It could also lead to Call events (liquidation or reset), benefiting discount bonds.
That also means that lower-rated CLO tranches could start trading at wider discounts to higher-rated tranches, especially if payouts to equityholders are seen to be at risk. From BNP:
On the CLO side, we also expect more decompression across tranches. We note that the capital structure is currently quite compressed. BBs have outperformed this year (they are ~80bp tighter ytd, see chart on the bottom right) but remain vulnerable to collateral deterioration. Also, short-dated CLO Equity, especially the ones with large Altice exposure, could be affected as a result of the drop in Equity NAV. Dispersion should also grow as deal-specific collateral quality and performance are critical to investors.
Broader demand for leveraged loans could also be suppressed because more CLOs will be prevented from reinvesting cash, as mentioned above.
But hey, at least it’s not systemic!
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* we made a typo and realised we mixed up data showing the total volume of Altice France debt in European CLOs with the global measure — we will update with total figures when we get the global number. Sorry [facepalm]