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June 05, 2020  

CLO Investors Waking Up to PIK Loophole

Junior bondholders in commercial real estate CLOs suddenly are worried about an often-overlooked provision in deal documents that could hinder cashflows in the event of loan defaults in the collateral pools.

At issue is a “payment-in-kind” mechanism in most deals that allows the manager to defer interest payments to investors in the most subordinate investment-grade tranches if the overcollateralization level drops below a prescribed threshold — as market pros fear could happen depending on the depth and duration of the crisis.

Under normal circumstances, CLO investors could count on issuers to buy defaulted loans out of the collateral pools and, if necessary, temporarily cover any interest-payment shortfalls in their roles as servicers. But with the default rate expected to rise and many managers struggling financially, the concern is they may no longer have the wherewithal to make payments to junior bondholders.

The so-called PIK provision attracted little notice before the crisis, in part because CRE CLOs rarely ran into trouble. Indeed, many bondholders acknowledged they weren’t even aware of the loophole, which is written into the documents of most, but not all, deals.

One investor who targets subordinate CLO securities said that lack of awareness helps explain what he sees as an unusual pricing pattern in the secondary market.

“A lot of these deals can defer interest payments to the C and D classes, and yet all the deals are trading at the same spot,” he said. “I’m not sure it’s a risk that bond buyers completely understood . . . I find that bizarre. I wouldn’t buy those deals right now.”

He added that many investors are oblivious to the PIK provision because while they’re common among CLOs backed by corporate loans, they’re rare in the commercial-mortgage market. When a collateral loan goes bad in a commercial MBS deal, for instance, the master servicer is obliged to advance payments to all bondholders as long as the money is recoverable.

But in CLOs that include a PIK option, the manager can defer payments to investors in the C classes — typically rated single-A — or lower tranches if the deal fails certain tests including overcollateralization.

“That is what is supposed to happen in the deal to protect the senior bondholders,” said an investor in triple-A-rated notes. “Yes, it’s a risk to anyone further down in the structure.”

Unlike a CMBS issue, where the par value of the bonds equals the combined balance of the collateral loans, CLOs typically are overcollateralized by up to 20%. In other words, the aggregate balance of the collateral loans is up to 20% higher than the face value of the deal.

All but one of the CLOs issued so far this year incorporate PIK mechanisms, according to a review of the deal documents. The one exception was an $800 million deal Arbor Realty priced on Feb. 21.

One manager said he recently inventoried his deals to determine which ones give him the option to defer payments. He noted that the option tended to be absent in deals structured by J.P. Morgan.

“No one ever focused on this because no one ever thought it would come into play,” he said. “But it’s becoming a real issue. We could have some of these deals that are 30% hotel or retail with issuers who are under duress [deferring payments] in the coming months.”

He added: “At the end of the day, if your bond starts to PIK, you probably have to worry about your principal. Whether you are being PIK’ed or not, you might get wiped out either way.”

But some investors are more sanguine.

“If, as a CRE CLO investor, the worst thing that happens to me is I have to defer a couple points of interest, and by doing that it means the credit makes it through, I think that’s a fine outcome,” one said. “Right now, the bonds I’m holding are trading at 80 cents on the dollar, so I can risk losing the coupon even for a year if I think the price will go up 10-15 points.”

For the time being, CLO bondholders throughout the capital stack continue to receive regular interest payments, indicating relatively few loan defaults among the collateral pools.

But the expectation is that the default rate will rise in the coming months, with some deals hit harder than others. Investors expect CLO managers will be quick to modify loans to prop up overcollateralization levels. The first to suffer a loss when a deal fails an overcollateralization test is the equity holder, which usually is the manager itself.