One of the many lessons to be learnt from the recent turmoil in the US sub-prime mortgage market is that CDOs are only as good as the assets that back them. CDOs backed by the weakest sub-prime loan vintages have been hit hardest, and lurid revelations about underwriting standards in parts of the industry have contributed to the ABS CDO pipeline closing almost overnight.
Things could not look more different in the CLO market, where each month record issuance volumes are racked up and asset managers are still falling over themselves to break into the market. The leveraged loan market must be completely immune to the kind of collateral quality concerns that have become so apparent in its ABS CDO counterpart.
But, of course, it isn’t. ABS CDOs were hit when weaker underwriting standards in the loans that backed them fed through into higher delinquencies and defaults. For a parallel in the CLO space one need look no further than the emergence of ‘covenant-lite’ lending.
Covenant-lite leveraged loans involve much weaker financial restrictions on private equity funds in LBOs. They are priced via a bond-style bookbuild process and only have to satisfy incurrence covenants.