A decade on from the depths of the global financial crisis, collateralised loan obligations (CLOs) are on track for a record year. There were 106 deals in the US during the second quarter, up 60% on Q1 and totalling $56.5bn, according to Moody’s Investors Services. Wells Fargo predicts it will be the biggest year yet of US issuance, hitting $150bn (£118bn) in 2018 compared with the previous record of $124bn in 2014. In Europe, H1 issuance was €21.57bn, surpassing total volume from 2013 through to 2016. It was almost keeping pace with the record €45.98bn issued in 2017.
CLOs are floating rate assets that provide a hedge against duration risk. They did not form part of the European Central Bank’s asset-purchase programme, so don’t have to adjust to the sudden loss of a major buyer. Yields on AAA tranches priced in euros were at 1.1% over Euribor at the start of October, while for BBB to B-rated tranches, they ranged from 3.6-8.5% above the base rate.
However, on the 10-year anniversary of the collapse of Lehman Brothers pundits eyeing the potential source of the next financial crisis have raised concerns about CLOs. Some managers are trying to get more aggressive with their loan documentation as demand for the asset class increases, according to Morningstar Cred it Ratings assistant vice-president for asset-backed securities (ABS) John Nagykery. “These features can enable or worsen the next crisis,” Nagykery said at the ABS East conference in Miami in September.
Investment managers increasingly adding to CLOs
There has been an increase of people using CLOs in their portfolios, according to Abhimanyu Chatterjee, head of asset and risk modelling at Dynamic Planner. “If the pool of debt underneath is of a well-diversified nature, in a rising-rate environment it makes sense to hold these loans, which are all floaters,” he says. The instruments can be complex and thorough due diligence is important, he adds. “Buying a CLO for the heck of buying a CLO is no good. That was the problem everyone had on the collateralised debt obligations (CDOs) during the financial crisis.”
Seneca Investment Management and Quilter Investors are among the discretionary fund managers with exposure to CLO funds. Both hold the Fair Oaks Income Fund, which invests in the highest-risk equity tranches, while Quilter Investors also holds Blackstone GSO Loan Financing. The asset class provides attractive risk-adjusted returns, appealing yield and is an important diversifier, according to Quilter Investors portfolio manager Rasmus Soegaard.
The asset class has been tarnished by the financial crisis but it’s important not to throw the baby out with the bathwater, says Square Mile head of research Victoria Hasler. “Reputation and fundamentals are often different. This is a problem with a lot of asset-backed securities, sometimes trading more on sentiment than fundamentals.” CLO defenders point out that senior tranches did not default during the crisis and the asset class has only been tarnished because the initialism is so similar to CDO.
Bonds funds versus CLO specialists
Due to CLO complexity, Hasler would prefer specialist teams of investors. “You want people who do it as their bread and butter. There are some corporate bond funds investing and you could argue it’s a little bit dangerous for people who don’t know them so well.” She would prefer that bond funds invest at the higher end with no more than 5-10% in the asset class. Square Mile tends to access CLOs via asset-backed securities funds, such as the Twentyfour Monument Bond Fund. A sophisticated investor with very large holdings in credit may want to go in via a dedicated CLO fund, she says.
Dynamic Planner rates CLO exposure as “very high-yield credit”, says Chatterjee. “We assign it the highest level of credit risk we can, just to be on the safe side.” Besides CLO specific risk, he says global default rates are currently non-existent and that interest rates are just starting to be hiked. “We don’t know how that’s going to pan out.”
‘Think of a CLO as a bank’
“From a basic perspective, a CLO is just another way of setting up a fund that invests in a diversified portfolio of traded institutional bank loans,” says Neuberger Berman portfolio manager Pim van Schie. The US asset manager launched the CLO Income fund in August with $77m seed funding. “In a mutual fund the investors are all coming in pari-passu and sharing in the pool of loans pro rata, while the CLO allows them to invest in the underlying loan pool at different risk/return points.
“As opposed to mutual fund shares, the CLO issues a number of debt tranches, bonds typically rated AAA through to BB, as well as an equity tranche. The issuance of that set of liabilities funds the purchase of the portfolio of loans.” Based on senior secured loans, CLOs can deliver yields higher than high-yield bonds but benefit from floating rate coupons, typically linked to Libor or Euribor, and stronger covenants to allow investors to take action if the corporate does not perform as expected.
According to Van Schie, CLOs represent more than half of the $1.1trn loan market. The majority of loans in a CLO represent an AAA-rated debt tranche but ratings go all the way down to a B, with a waterfall of cashflows being paid out in order of rating. A separate equity tranche, representing around 10% of the CLO, gets to share in any excess cashflow. They are priced with an internal rate of return currently around 10-12%.
“Investors find it useful when we suggest thinking of a CLO as a bank,” says Van Schie. “Just like a bank, the CLO lends money at a certain yield through the purchase of this loan portfolio and finances itself cheaper through the issuance of bonds, capturing the difference for the benefit of the investor.”
Breaking down the different tranches
Seneca Investment Management’s primary exposure to CLOs, which represents 2% of its open-ended multi-asset funds, is via equity tranches. Fund manager Richard Parfect says: “It gives them a controlling influence on how the CLO is structured. They agree with the underlying CLO manager what goes into the portfolio, the fees and the various rules they will abide by.”
Twentyfour Asset Management, on the other hand, doesn’t have any equity exposure. Fund manager Aza Teeuwen says: “We are not a hedge fund. We don’t need double-digit returns. A lot of our funds require liquidity, and equity is not as liquid as, say, a BBB-rated tranche.” Twentyfour has held European CLOs since 2012. Its open-ended Dynamic Bond and Strategic Income funds have less than 12% across ABS while the closed-ended Income fund holds 33% in CLOs alone.
Twentyfour breaks down CLO analysis into three parts. Teeuwen says: “We spend a considerable amount of time analysing the CLO manager underwriting them and focus on the business, investment process, risk management, IT systems and so on.” When Twentyfour is comfortable with the CLO manager, it then draws on the resources of the multi-sector bond team, which manages funds such as Dynamic Credit and Select Monthly Income, to assess the pool of assets. He says: “They might come back to us with two or three names they don’t like.” The team then conducts cashflow analysis and stress tests. The final step is to assess the supporting CLO documentation.
Covenant standards drop
In May, a court ruling in the US overturned a risk retention requirement introduced under the Dodd-Frank Act. The ‘skin in the game’ rules required CLO managers to hold 5% of their deal to align their interests with those of the investors.
Moody’s describes the move as credit neutral. “More players in the market will potentially increase competition for leveraged loans, which in turn could lead to a further erosion of already weakening underwriting standards,” the ratings agency says in its Q2 2018 update on the US CLO market. “At the same time, competition for leveraged loans could improve borrowers’ ability to refinance and reduce their near-term default pressure.”
Covenant standards have been dropping for the past couple of years, according to Architas investment manager Mayank Markanday. “There’s been huge amount of issuance of covenant-lite loans. CLOs are effectively using the same loans but securitising them,” he says. “It’s not a problem at the moment but we are seeing corporate profitability and corporates generally in good shape. Because there is so much demand for yield from investors out there it acts as an incentive for issuance of lower-rated CLO tranches, below investment grade, which is where the risk is.
“If you start to see problems in the economy, corporates defaulting as they are not able to fulfil the loan requirements, it will be felt in these lower tranches. That’s just the way this securitisation works.” In Europe, documentation weakened in the first quarter and spreads tightened in response to strong demand, but that reversed in Q2 and Q3, according to Teeuwen.
Red flags for DFMs
Seneca and Quilter Investors have CLO exposure but others are more cautious. Architas sold out of its position in the Fair Oaks Income Fund in Q1. “It was a decision we took to reduce risk. We did pretty well out of that strategy,” Markanday says. Its main exposure to CLOs is now through the Twentyfour Income Fund, which invests in other types of debt securities, such as high-yield, mortgage-backed and asset-backed. Falling interest rates or rising default rates could be bad news for the asset class.
“You can envision a situation in the future where interest rates start to rise while the economy slows down. Some of these corporates that are highly levered could be in trouble and start to default,” he says. However, particularly in the US where most loans originate, he does not expect this situation anytime soon.
The multi-manager team at BMO Gam holds no direct exposure to CLO investments but many underlying funds are invested in the space, including Legg Mason WA Structured Opps and the Twentyfour Dynamic and Monument Bond funds. Investment manager Kelly Prior has noticed a sharp increase in funding from the loans versus the bond market in recent years. “This alone is not a bad thing as long as the terms within the loans and CLOs remain suitably tight,” she says, “and this is where the red flags are perhaps being waved by the naysayers at the moment.
“There are several layers of risk that need to be monitored: the quality of the loans, the quality of the CLO structure and the quality of the CLO manager. It is the first of these that has seen a marked deterioration and what makes us slightly wary of the sector at this point in the cycle.”
However, according to Hasler, it is a much wider asset class than people perceive it to be. She says: “The higher-quality tranches would be much lower risk and lower return than high yield, whereas the lower-rated tranches can rival equity returns at times. It’s a vast scale and that’s the bit people tend to miss.”
