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All CLO agreements contain a series of protective covenants that place guardrails on the loans to companies made by the CLO portfolio manager. Typically, a CLO is limited to investing only 7. If existing holdings are downgraded, placing them in the CCC category, then the CLO manager is essentially obliged to direct future lending towards higher-grade borrowers. Thus, drops in the prices of lower-grade loans, which are inevitable in the current crisis, will further require CLOs to skew future lending towards safer borrowers, in order to maintain the collateral levels mandated in the debt issued by the CLO.
CLO managers have entered the pandemic crisis with portfolios over-weighted with loans that are most likely to be downgraded to the undesired CCC category. Moreover, as of March 31, the average bid for U. This is a crisis hiding around the corner. Given the covenant constraints and current market conditions, it is pretty clear that CLOs will be unable or at least unwilling to extend any additional capital to the most leveraged borrowers.
It is worth noting that in two recent debt restructurings — Deluxe Entertainment and Acosta — CLOs declined to participate proportionately. Small and mid-cap enterprises SMEs are not immune to the leverage problem, but they are less visible due to the private nature of the bulk of this market.
CLOs are not a major player in this segment, but over the past decade, a desire to reach for yield has attracted other providers of risky debt capital to the balance sheet of SMEs. Middle Market Research. Although it is difficult to obtain data on SME balance sheets, we would expect a proportion of these companies to be reasonably highly leveraged, given the environment and the availability of credit. It is also unclear whether existing creditors have the funds and flexibility to inject additional capital.
Given the inevitable downturn in the value of their existing loans to SMEs following the pandemic at least some of these investment funds will be facing some pressure. In any event, many SMEs will have little available collateral to offer lenders and face more uncertain commercial futures than their larger competitors, who benefit from relatively large and stable market shares and can access more efficient capital markets.
Where Does This Leave Us? Given that their bank credit lines are already full, the effective closure of the main sources of liquidity for lower-rated companies leaves only one plausible private-sector source for these companies: private capital investors, specifically distressed debt funds, private equity, private debt funds, and hedge funds. But in the current circumstances, with the debt of many highly leveraged companies trading well below par, investment by these players will likely entail some form of capital restructuring.
This can be a complex process, requiring extensive due diligence and involving negotiation among many parties. The bottom line is that without a meaningful government intervention, a very large number of highly leveraged companies will almost certainly be forced into free-fall bankruptcy as a direct result of the pandemic, even though there is plenty of cash in the financial system that could tide them over.
This seed capital from the Treasury will be further increased by contributions from the Federal Reserve. Although several details of the program have yet to be specified, we are concerned that their benefits for leveraged companies may fall short on several fronts. To begin with, the Federal Reserve has yet to define the collateral requirements for loans to large and medium-sized businesses. If it requires — as it generally has done in the past — that these loans be fully secured by collateral, the act will not help those highly leveraged companies that do not have unpledged collateral, with very few exceptions.
Moreover, the CARES Act also excludes from the small-business portion of the package the small companies that are backed by private equity firms. As a result, the act does little to protect many of the companies and jobs that are arguably most at risk from the economic shock delivered by the coronavirus pandemic and penalizes perfectly good small companies that happen to be owned by private equity investors.
What should the government do to fix or clarify the program? These three amendments should be urgently considered: Remove the affiliate exclusion of small companies backed by private equity from the small business assistance provisions of the act. This time around, creditors will need to take a hit. This would involve large scale debt write-offs and years of ongoing negotiation and litigation. This is good news for bankruptcy lawyers, but little else.
Using data since , forecasts for lower GDP growth point to a significant decline in US corporate earnings growth. This is consistent with the decline witnessed in Meanwhile, the multiple on which investors are willing to pay for these declining earnings is near a 20 year high. That looks like complacency.
On mobile: review chart in landscape mode Our core concern is that markets are under-pricing solvency risk. The longer the virus continues unchallenged, and the economy remains impeded, the greater the probability that markets start to price this risk-in.
The portfolios remain liquid, highly diversified and defensively positioned. Within credit we are underweight high yield bonds as the market has failed to adequately price in both downgrade and default risk. On a relative basis we prefer US investment grade bonds, which will benefit from Fed purchases, but could still suffer from rising defaults.
Two weeks ago we reduced equities to underweight. On mobile: review chart in landscape mode Download the PDF This investment Blog is published and provided for informational purposes only. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated. Want to know more about the Equity Markets?
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The only way this situation could be stopped was by a buyer with sufficient firepower to put a floor under the market. Enter the Bank of England, which has a mandate to ensure market stability —as well as targeting inflation. They knew they had plenty of assets to meet collateral calls and they knew their solvency was improving. However, the money was not where it needed to be and in a crisis environment liquidity becomes king.
The immediate response from pension funds has differed between those that maintained their hedges and those that had hedging reduced. Our experience of the clients where we have discretion fiduciary management has been for all hedges to have been maintained.
It is now clear that pension funds need to prioritise their investment objectives for the short term. In order of importance, we are advising pension fund investors to adopt the following priorities: liquidity, liability hedging, and expected returns. This means that in many cases pension funds will reduce their expected returns to support their hedging programmes. Leverage in the LDI system is reducing rapidly. This means that more money will be required up front to support hedges. This is being driven by advisers, trustees, corporates and the LDI managers who were all looking to avoid a repeat of the last week of September.
Across the industry, we expect to see higher levels of collateral and less leverage. Put another way, the multiple of hedging to assets gearing is expected to fall from 2x-4x to 1x-3x. This is a big change. For context, imagine all mortgage holders were suddenly told to reduce their mortgage loan to value ratio from 75 per cent to 50 per cent in a few weeks. It would cause a lot of selling of savings. Things are no different in the pension world where, to reduce leverage, pension funds must sell other assets.
We are starting to see the impact of this with suspended redemptions for property funds and higher dealing costs for bond funds. While deleveraging will cause many pension funds to sell assets, there are a number of long-term investors that are ready to buy assets, potentially at a discount. These include pension funds that have a long-term time horizon and can tolerate lower levels of liquidity. As with any crisis, particularly one involving liquidity, there will be winners and losers.
Lessons to learn In the longer term, pension funds, investment advisers and LDI managers will reflect on lessons learnt. The issue is already getting the attention of regulatory bodies, but it is hard to say at this point what may change. The overall premise of LDI has provided a lot of protection to pension funds through massive economic downturns. It has allowed companies to plan with certainty and trustees to reduce volatility. What seems likely to change is the operation of LDI.
Reduced leverage, more frequent trading and greater oversight all seem likely. Feedback we have received from the market suggests that fiduciary managers have typically managed this crisis well, and that having one party with oversight over all assets allowed quicker actions to be taken.
Meanwhile, the fundamental issue remains of weaning the global economy and the financial markets off decades of loose monetary policy. Over the past couple of weeks, the UK gilt market was at the centre of a volatility storm, but threats are all around investors. The gilt market is the foundation of the UK financial system, but we see high volatility in even bigger markets, like the US Treasury market.
Investors should be aware that the gilt crisis of September may be the first of many as the world moves to combat higher inflation, tighten monetary policy, and deal with the massive geopolitical shocks we have seen so far in If you think that Freddie and Fannie had brand equity, then they suffered from a liquidity crisis, because once their borrowing costs were held down, they became profitable again.
This entry was posted in Uncategorized by Arnold Kling. Bookmark the permalink. The issue was tight monetary policy arising from a poorly understood instrument: IOR. The question to have asked was liquidity problem cause or monetary problem cause. The monetary problem caused liquidity and solvency issues.
The effort to respond to the liquidity crisis caused bad tight monetary policy. If it has brand equity or franchise value, the market still fails to recognize it. Bryan Willman on said: Seems to me a that huge issue here is the dual nature of intermediation.
Banks borrow short and lend long. A side effect or necessary colateral to that is that they also borrow hard and lend soft.