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Collateralized loan obligations: finding opportunity amid uncertainty
- Collateralized loan obligations (CLOs) have been resilient through previous periods of market uncertainty.
- Structural features and attractive fundamentals make CLOs a compelling investment opportunity in the current market environment.
- CLOs offer many advantages, but today’s uncertain economic environment, higher levels of leverage and other complexities warrant partnering with a skilled manager to build diversified portfolios and navigate risks.
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:
- Term structure: First and foremost, CLOs are closed-end vehicles and generally have 11 to 13 year terms that preclude interim liquidity. CLO-issued debt is available for the full term of the vehicle and is not generally subject to forced liquidation, even if market values in the underlying portfolio go to zero. As a result, CLO portfolios are well-insulated from swings in market valuations.
- Diverse portfolios of senior secured bank loans: The proceeds from debt and equity issued by CLOs are used to purchase bank loans, which are generally secured and have first lien claims in a company’s capital structure. A CLO’s strict rules enforce minimum ratings quality and require minimum levels of portfolio diversification, greatly reducing concentration risk among industries and individual companies.
- Active management: Traditional CLOs are actively managed for the first 3 to 5 years after they are issued. This gives managers the ability to swap out of bank loans that may have become riskier since they were initially purchased, or to purchase out-of-favor bank loans that may be undervalued.
- Structural “guardrails” in place: While CLOs generally ignore swings in the market value of the underlying bank loan portfolio, they are sensitive to realized losses resulting from defaults or distressed sales and unrealized credit risks. If losses exceed a pre-determined threshold, interest income from the bank loan portfolio that would have otherwise been paid to equity or other junior debtholders is used to gradually pay down the CLO’s principal debt, starting with the most senior debt. Once leverage has been reduced to more manageable levels and asset coverage tests are passing, CLOs can resume paying out distributions to equity investors.
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:
- Upside potential: Bank loans have largely rallied from the lows of March and April, but given the challenging economic outlook since the onset of the coronavirus, most still trade at a discount to par (Figure 1). However, it is reasonable to expect that the vast majority of bank loans will ultimately repay at par, either at maturity or when they are refinanced. For CLO equity investors with leveraged exposure to bank loans, this “pull to par” trend could generate impressive return upside.
- Relatively low financing costs for new CLOs: Demand for yield is stronger than ever as central banks have used every tool at their disposal to push rates to new lows. Investors have also realized that there has never been a default in AAA/AA-rated CLO debt, and have driven spreads on these instruments down to pre-COVID levels. As a result, today’s CLOs have been able to lock-in highly attractive financing rates, which accrue to the benefit of equity investors.
- Addition of LIBOR floors: LIBOR has fallen precipitously year to date. As a result, most new bank loans issued today come with LIBOR floors, which set a minimum coupon level. As an example, a bank loan with a coupon of LIBOR plus 4% might have a LIBOR floor of 0.5% to 1%, meaning that if LIBOR falls below the floor (3-month LIBOR currently stands at roughly 0.22%) the effective coupon paid by the bank loan is 4.5-5%. In a low rate environment, this benefits CLO equity investors because debt issued by CLOs is not subject to LIBOR floors greater than zero. Effectively, the CLO equity investor can earn the spread between the LIBOR floor and actual LIBOR. On a levered basis, this can produce meaningful return benefits.
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.
The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the $US-denominated leveraged loan market
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A word on risk
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