Fair Oaks Reflections – Issue 6

Managing credit risk and avoiding credit losses are key drivers of CLO returns. A strong focus on potential sources of credit risk is essential when considering investments at this point in the credit cycle.

Contrary to general expectations of widespread defaults, Fair Oaks Capital believes that corporate default losses over the next five years will be concentrated in certain industries facing common challenges. Particularly important for CLO investments, we believe that many CLO managers are not sufficiently focused on avoiding or reducing exposure to these sectors.

Corporate credit investors are (rightly) focused on the challenges of high financial leverage, weak documentation and how to position portfolios for a turn in the economic cycle. The structure of traditional CLO management teams (analysts focused on sectors) and portfolio requirements of CLO structures (encouraging maximum diversity) support a defensive approach based on loan-level credit selection driven by fundamental corporate analysis and scenario cash flow modelling. However this bottom-up approach often limits broader sectorial views.

While we agree that detailed fundamental analysis is crucial to avoid idiosyncratic defaults, we believe that loan and bond managers should be much more focused on implementing a strong top-down view to ensure they are avoiding industries facing secular headwinds.

Our position is based on the premise that while the default rate may be highest in cyclical industries over the next five years, the more relevant default loss rate will be highest in industries challenged by the impacts of new technology and the resulting changes in consumer behaviour. This is because recovery rates will tend to be significantly lower in sectors experiencing a secular, permanent, loss of revenue and profitability.

Many of the secular changes that threaten industries are already happening or at least identified. Retail is the most obvious example due to the migration of retail spending online which has already caused significant stress among traditional retailers. In 2018, 7.3% of retail issuers rated by Moody’s defaulted, while the rate for all corporates was only 1.1%¹. While we expect this trend to continue, we still see several retail loans held in many CLOs. Managers who are generally cautious on retail exposure will often cite the following reasons for holding these loans:

• dominant niche players (e.g. Michaels Stores, arts and crafts materials retail, >$1.0bn US CLO exposure);
• low-levered and/or diversified (e.g. Ascena, fashion retail, >$600m US CLO exposure²); and
• somehow immune to online competition (e.g. Bass Pro, sporting goods retail, >$1.8bn US CLO exposure; Douglas, perfume retail, >€400m Euro CLO exposure²).

We believe that these types of exceptions have in other cases proven to be short-lived and insufficient defence against the negative secular trends.

Based on our experience and regular discussions with a large number of managers, we are of the strong view that analysts and portfolio managers often overestimate their ability to predict the rate and extent of decline of an industry facing competition from a new technology or other disruptions, and simultaneously underestimate the impact these macro challenges impose on individual companies they are invested in.

The high default losses experienced a decade ago from lending to the yellow pages sector in the US and Europe, for example, should have served as a cautionary reminder about the dangers of lending to a cash-generative but declining industry.

Like retail, TV and radio broadcasting have faced existential challenges to their business models from technology-enabled changes in consumer behaviour, i.e. the ability to use new technology to watch and listen to content without advertising. Despite the $6.3 billion default of radio channel operator iHeart Communications in 2018³, CLOs still hold over $2.0 billion of loan exposure to highly-levered television channel operator Univision². The reasons cited for continued exposure to these names despite the threats from new technology are similar to those for maintaining retail exposure: a belief that companies will withstand the pressure due to their niche positions (e.g. Univision’s Spanish language channels) or immunity to secular trends (e.g. continued in-car radio listening).

Other examples of sectors we have been focused on, as potential victims of technological change, include telecom (voice revenues in particular), cable television (excluding broadband access revenues) and intermediary businesses such as insurance broking.

Although technology has the potential to disrupt many, if not all, industry sectors, we believe the industries mentioned above are those in which companies face the highest existential threats and thus lenders face the highest potential default losses.

Future Reflections will touch on other factors which we have identified as potential drivers of credit quality beyond the next five years such as the impact on business models across industries with high carbon footprints (whether from reduced consumer demand, regulatory changes or new carbon pricing regimes).

FOOTNOTES
1.Source: Moody’s Annual Default Study, February 2019.
2. Source: Intex.
3. Source: S&P Global Market Intelligence, February 2018.