Financial engineering made risky credit seem safe. Now they are facing a major test.

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Cirque du Soleil canceled its famous shows in Las Vegas and around the world last week, disappointing fans. Over 100 mutual funds also suffered as the value of circus loans fell.

The company is one of thousands of companies whose loans with similarly risky junk-rated debt have been bundled into funds that have been sold to investors around the world.

Some of the loans that are popular with CLOs have seen sharp falls

BCP renaissance parent

Heard 203 CLOs *

Price drop †

-16.0 Cents on the dollar

McDermott International

155 CLOs

CDS US intermediate level

Holdings (Cirque du Soleil)

117 CLOs

GIP III Stetson I

127 CLOs

Field wood energy

90 CLOs own two loans

The idea behind this fund is known as secured loan commitments, or CLOs, is that different companies are extremely unlikely to have problems at the same time. By pooling and diversifying their holdings, these funds could convert risky loans into highly rated, safe investments that generate better returns than government bonds.

CLOs have been booming in recent years when investors sought income in a world of ultra-low interest rates. This boom, in turn, fueled the demand for risky leveraged loans. The rapid growth prompted global regulators to warn of possible instability in the financial system. The Bank of England even compared the industry to the subprime mortgage boom before the 2008 financial crisis.

Then came the coronavirus. Its far-reaching effects on all industries – canceling flights, emptying conferences, shortening vacations, closing restaurants, emptying cruise ships and closing schools and offices – threatens to undermine the central assumption that enables CLOs to convert risky loans into investments with a triple-A rating: that diversification of loan portfolios protects investors.

“These things have been structured for perfection and for economic times,” said John Griffin, a professor of finance at the University of Texas at Austin who studied the CLO market. He believes that many CLOs are likely to suffer losses, although others in the industry say it’s too early to say.

The cancellation of the Cirque du Soleil show made it harder to repay his already risky debt. According to Trepp CLO, which is tracking the industry, the price of its senior fixed-term loan fell to 69.5 cents a dollar after the shows were canceled, down from 92.5 cents on Feb.27. On Wednesday, rating company

Moodys Corp.

The rating of Cirque du Soleil lowered deep into the speculative area and referred to a “widespread deterioration in credit quality” that was triggered by the coronavirus pandemic.

A spokeswoman for Cirque du Soleil said the company was “working day and night to deal with this difficult situation” and declined to comment.

The CLO trade may not be as big as the subprime mortgage market that ruined the US economy a dozen years ago, but it has become big business. Financial engineers have created more than $ 700 billion in CLO debt in the United States and Europe in recent years. Well-known managers contain

Black stone‘S

GSO Capital Partners, Neuberger Berman and

Eaton Vance Corp.

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According to the International Monetary Fund, in recent years these funds have bought more than half of all leveraged loans, a risky type of debt that private equity firms use for buyouts. For example, private equity firm TPG bought Cirque du Soleil in a 2015 deal that left the circus with nearly $ 900 million in debt that was later bought by dozens of CLOs.

TPG declined to comment.

A CLO works like this: The fund manager collects hundreds of risky loans from various borrowers. It then wraps them in triple-A-rated paper backed by smaller, riskier pieces of lower-rated paper and stocks that are sold to investors. Banks in the US and Japan, insurance companies, hedge funds and asset managers have amassed CLO investors.

The cash flow collected from all loans is used first on the highest rated securities. If there is a problem with the underlying credit, the riskier, lower-rated bonds will not be paid off. According to the rating company, a CLO bond with a triple A rating has never failed

S&P Global Inc.

CLOs existed before the financial crisis, but have grown in popularity in recent years. That created a source of credit for risky businesses to tap into. Because CLOs competed for loans to invest in, borrowers could borrow more debt per dollar of profit at lower interest rates and ask for looser terms called covenants.

The industry is now faced with impending problems. Lots of money invested in the same loansso that one large default will cause many losses. The top 20 loans, which saw the largest price drops from February 27 to March 11, were spread across nearly 500 funds, according to Trepp data. Trepp tracks 1,250 CLOs, which is about 85% of the market.

Geoffrey Horton, CLO analyst at Barclays, says a lack of concentration in an industry should protect investors. The largest sector concentrations in US CLOs are healthcare and pharmaceuticals with 12.5% ​​for the median fund, followed by high technology with more than 10%. These are industries that could partially benefit from the coronavirus pandemic. Frontline industries such as hotels, games and leisure, retail, energy and consumer goods, and transportation together account for 14.8%.

Another problem is that the industry may have underestimated the likelihood that different industries could get into trouble at the same time when an unexpected event like the coronavirus occurs.

“When you think about a Black Swan event, I mean that is going to be the event,” Jaret Seiberg, an analyst at Cowen Washington Research Group, said at an investment conference in Las Vegas in February.

A 2017 study of 136 post-crisis CLO deals found that default correlation assumptions should have been three to four times higher than those used by S&P. The results suggest that the credit risk on triple-A tranches of CLO deals may be underestimated by 26%, according to Griffin of the University of Texas, who wrote the study.

An S&P spokesman said: “We are not commenting as we are facing a major crisis that is rocking the financial markets.”

The Treasure Island Hotel in Las Vegas is promoting the Cirque du Soleil Mystère Show on Saturday.


Photo:

Ethan Miller / Getty Images

Avoiding a sudden spike in defaults across the board is vital for CLOs as a low expected correlation between high risk borrowers allows their debts to be pooled and broken down into safer investments.

Joe Pimbley, credit risk advisor at Maxwell Consulting in New York, said correlations are difficult to get right. Subprime mortgage-linked bonds suffered losses in 2007 and 2008 because investors, banks and rating firms mistakenly assumed that many US homeowners were unlikely to default all at once, he said.

“The bottom line is that we don’t know any correlations. The best we can do is our best guess, ”added Mr. Pimbley.

CLOs survived the last crisis well. While the underlying loans the funds hold are arguably riskier than before, CLOs have introduced features to better protect investors, such as:

“The structures are very well designed for situations like this,” said Tom Majewski, managing partner of Eagle Point Credit Management LLC, which has invested approximately $ 2.9 billion in equity and lower-rated CLOs.

Write to Cezary Podkul at [email protected] and Paul J. Davies at [email protected]

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