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Income Investing

Collateralized loan obligations: finding opportunity amid uncertainty

Himani Trivedi
Head of Structured Credit
Top down view of people on mulicolored pavement

Highlights

In the years leading up to 2020, many market-watchers pointed to signs of overheating in the corporate credit markets and were predicting an imminent collapse. Collateralized loan obligations (“CLOs”), which are leveraged pools of floating-rate corporate debt (commonly referred to as bank loans), were viewed by many as the poster child for the market’s excesses. Confused with subprime collateralized debt obligation (CDOs) that triggered the Great Financial Crisis of the last decade, the headlines suggested that CLOs would be the cause of the next recession. In short order, it was predicted that CLOs would crack under the strain of a broader market unwind, leading to losses – and painful lessons – for yield-hungry investors.

Driven by pandemic-panicked selling in March 2020, credit markets lurched downward, and it appeared that the day of reckoning had finally arrived for CLOs. New issuance came to a halt, prices of CLO instruments plunged and a wave of rating downgrades began to strain CLO portfolios.

However, the much-anticipated shattering of the CLO market has not come to pass and CLOs did not cause the next recession. The initial panic selling self-corrected in one of the quickest rebounds the CLO market has ever seen. As quarterly earnings outperformed dire predictions and governments and central banks have aggressively intervened, prices of bank loans have recovered. As a result, CLO debt spreads have returned to almost pre-pandemic levels and CLO portfolio losses have generally stabilized. This rebound across all asset classes has been largely driven by extraordinary measures from the central banks seeking to reflate risk appetites through seemingly unlimited quantitative easing. In the CLO space, the resiliency of the CLO structure, which has successfully weathered market swings and liquidity crunches since the mid-1990s, continued to demonstrate its strength even during this unprecedented economic shock. Today, market conditions point to a potentially opportune moment to put money to work in this battle-tested asset class.

CLOs have shown resiliency in times of market stress

CLOs borrow money from the debt markets to purchase pools of bank loans. Yet despite the levered nature of their underlying portfolios and the complexity of their structures, CLOs have shown resiliency in the face of market swings for several key reasons:

Investing in CLO equity: the time is now

Despite the market’s impressive bounce back since March, there are several reasons that the current environment supports investing in the equity of CLOs:

Figure 1

The importance of manager selection

CLO equity investments have many advantages, but there are also investment risks, making CLO equity investors highly dependent on experienced CLO managers. In today’s uncertain economic environment, the prospect of credit losses is very real, and skilled CLO mangers can help avoid realized losses that may occur through either through defaults or trading. Given the relatively high levels of leverage in a CLO, it is important for CLO equity investors to partner with a manager who can not only build diversified and resilient portfolios, but who can prudently add risk when warranted.

While a CLO’s financing costs are effectively locked in for the life of the vehicle, CLO equity investors can actually benefit if credit spreads increase over time because CLOs can actively reinvest into higher spread bank loans, potentially increasing the cash flow paid to equity investors. Of course, this benefit can be diminished if the CLO portfolio sustains losses due to defaults and trading activity, underscoring the importance of investing with a skilled manager capable of preserving value in challenging market conditions.

In the months immediately after the coronavirus began to roil markets, our CLO investment team recognized the need to reduce risk and capture potential upside opportunities. As we assessed the new economic reality imposed by the pandemic, we began to gauge the demand outlook during the shutdown phase during late spring/early summer and during the re-opening phase that followed. We categorized companies according to the expected change in demand for their services over time and identified potential sector winners (e.g., home improvement, drive-thru restaurants) and losers (e.g., theaters, fitness) over the short and medium-term.

CLOs are subject to numerous portfolio restrictions that are intended to serve as guardrails protecting debt investors, but CLO managers with deep expertise navigating these criteria can skillfully reposition portfolios and produce better outcomes for both debt and equity investors. As markets have stabilized and forward-looking visibility has improved, we believe CLOs are well-positioned to weather future bouts of volatility while benefiting from steadily improving market conditions.

We believe CLOs are well-positioned to weather future bouts of volatility while benefiting from steadily improving market conditions.

 

Seizing the opportunity

Although CLOs are often viewed with apprehension due to their embedded leverage and high complexity, 2020 has once again highlighted their ability to successfully withstand high levels of market volatility. We believe the current market environment represents a compelling opportunity for potential CLO equity investors, as low CLO financing rates and discounted bank loans converge to produce a potentially attractive arbitrage. In addition, investors who are able to invest alongside CLO managers as majority owners of the equity tranche can further improve return outcomes through greater alignment of interest with the manager.

Nevertheless, the levered nature of CLO portfolios and the complexity of the CLO structure warrant appropriate levels of caution, and underscore the importance of partnering with a skilled manager with a robust platform and significant alignment of interest. Proper due diligence is key, because the right manager can enable a CLO equity investor to capture upside opportunities while mitigating downside risk.

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Endnotes
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; loss of principle is possible.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
This commentary provides general tax information. Nuveen Asset Management, LLC is not a tax advisor. Clients should consult their financial professionals before making any tax or investment decisions. This information should not replace a client’s consultation with a financial professional regarding their tax situation. Neither Nuveen nor any of its affiliates or their employees provide legal or tax advice. Please consult with your personal legal or tax professional regarding your personal circumstances. Tax rates and IRS regulations are subject to change at any time, which could materially affect the information provided herein.

A word on risk
This report is provided for general information purposes only and should not be construed as specific legal, tax, or financial planning advice. All opinions and views constitute judgments or relevant information as of the date of writing and such information may become outdated or superseded at any time without notice. This report contains information from third party sources believed to be reliable but are not guaranteed as to accuracy and not necessarily all inclusive.
This report is not intended to constitute an offer, solicitation, recommendation or advice regarding any securities or investment strategy. This information should not be regarded by recipients as a substitute for the exercise of their own judgment. Resources are provided as a courtesy and do not constitute an endorsement, authorization, sponsorship, or affiliation with Nuveen with respect to any resource provided. Past performance is no guarantee of future results.
An investment in any municipal portfolio should be made with an understanding of the risks involved in investing in municipal bonds, such as interest rate risk, credit risk and market risk, including the possible loss of principal. The value of the portfolio will fluctuate based on the value of the underlying securities.
Clients should contact their tax professional regarding the suitability of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/ losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer.

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