The collateralised loan obligation, or CLO, is often stymied by its similarity in name to the infamous collateralised debt obligation, or CDO, of crisis fame.
While the CDO has been pilloried since the crisis, most notably in the Hollywood hit The Big Short, its less controversial cousin the CLO has been quietly getting on with business and trying to shake off any association with toxic CDOs.
Put simply, a CLO is primarily backed by senior secured corporate loans —unlike the crisis era CDO, which was backed by mortgage and non-mortgage debt and was often a funding tool for the repackaged MBS debt, which was destroying bank balance sheets.
Like MBS, CDOs performed abysmally during the crisis, while CLOs did not, given the low levels of corporate defaults during the crisis and strong recoveries on first lien loans. Since the crisis, therefore, while the CDO asset class has collapsed the CLO has flourished, recording a record issuance year in 2014.
The two largest global markets for CLOs are the US and Europe and while there are some cross-over issuers and investors who play in both markets, homogeneity between the two is still slowly developing.
The US is the larger of the two markets by a considerable margin and is reaching a level of sophistication that is starting to excite both issuers and investors. Demand is spiking with the assumption of global interest rate rises.
Betting on the US
The US remains the largest CLO market in the world and while issuance last year was down by 32% — with $63.5bn of notes issued across 136 deals — it is still far ahead of any other geography.
In 2014 the US saw record issuance of around $116bn and in 2015 there was about $93bn sold to investors.
It has often been said that the US CLO market funds Main Street America and a casual observer would only have to look at the top borrowers scattered throughout US CLOs to see some truth in that statement. With companies such as Dell, Toys ‘R’ Us, American Airlines, PetSmart, Vodafone and SeaWorld among some of the top 250 obligors across the market as recorded by S&P, US CLOs fund a diverse portfolio of corporate America that employs millions of people.
“One of the reasons for the broad appeal of the CLO asset class is that investors are getting access to the US domestic economy,” says Oliver Wriedt, co-CEO at CIFC, a CLO manager and issuer in its own right.
The CLO market also has a long track record of performance for investors to look at and, unlike, for example, the US RMBS market, it performed well during the crisis, which its adherents say is a sign of its resilience.
“The loan market has been tried and tested both in the 2001/2002 recession and again in the 2008/2009 recession,” adds Wriedt. “Senior secured loans have proven to be a recession-proof asset class, mark to market notwithstanding.
“The great financial crisis was a true test of whether the CLO structure worked or not.”
Maturing market
Tom Majewski, managing partner and founder at Eagle Point Credit Company, an investor in CLOs, says the US CLO market — which funds about half of all large senior secured bank loans in the US, over $850bn — is continuing to evolve.
It is a market which has attracted
more investors as it has grown over the past couple of decades, and Majewski
says it is still gaining traction with alternative investors.
“What we are seeing is more investors participating in the market. New investor interest, domestically and from Asia, particularly China, has picked up,” he says. “With the evolution of the US CLO refinancing market, we are seeing triple-A investors who are buying out of funds benchmarked to the Barclays US Aggregate Bond Index.
“They believe rates are going up and, as a result, that fixed rate index would suffer as rates rise.”
The refinancing market has always been a feature of CLO issuance but it has taken on a new lease of life in the past year.
A phenomenon which used to only exist in brief windows has now become a year-round investment opportunity, with buyers willing to purchase refi paper whenever issuers come to market.
A healthier CLO refinancing environment means there is more variety and investors have the choice to buy short dated refinanced paper or longer dated new issue securities, which Majewski sees as a sign of a maturing CLO market.
“There is now a time curve on CLO debt tranche pricing. While this is common practice in the broader bond market, it is relatively novel in CLOs,” he adds.
“Longer duration CLO bonds are trading wider than shorter bonds. CLO investors are capitalising on this trend and can invest with different tenor expectations.
“This has helped broaden the CLO investor base.”
Refinancing has been a theme in both the US and in Europe this year as leveraged loan prices continue to rise on the back of demand for floating rate paper.
Credit concerns
A new dynamic for CLOs in the last year has been the tightening of loan spreads, leading to fears that managers will dip into riskier pools of collateral to increase deal returns. As demand for floating rate credit has increased globally CLOs have seen retail loan funds become competitors in the syndicated loan market.
The rise of covenant-lite loans which have emerged in this competitive loan environment means that credit remains a concern for some CLOs.
At the beginning of 2016 energy markets slumped and a number of CLOs were shown to be overexposed and now retail concerns are emerging.
Certain US retailers, such as Sears and J Crew, continue to be a worry and managers will need to make sure they balance deal economics with credits that are likely to survive over the long term.
“We have to look further ahead to identify credit concerns. We are very deep into the credit cycle and while at some point you would expect the economy to slow, or even contract, it is not something we are seeing in the near term,” says Wriedt.
“But with every cycle you have to be mindful that as a CLO equity investor you are long on a levered basis on a diversified portfolio of non-investment grade credits that are each going to have their own unique challenges in an economic
downturn.”
Alternative CLO market
While investors can invest in the broadly syndicated loan market that backs some of the world’s largest corporates, buyers can also look for increased returns by betting on SMEs.
“The middle market CLO space has expanded over the last several years as the investor base has been searching for yield,” says Ted Koenig, president, CEO and founder of Monroe Capital, a middle-market loan investor and CLO issuer. “As yields have compressed in broadly syndicated loan CLOs, many of those investors have crossed over into the middle market.
“There are a handful of high quality asset managers, Monroe included, who have been serial issuers in the middle market that are able to continue to drive issuance and product.”
Koenig adds that unlike the broadly syndicated loan CLO space, which is 80% covenant-lite, the middle market CLO space still has covenants on loans.
This would aid with recovery in a recession and offers investors who are worried about loan covenants an alternative product. Koenig says on average, middle market companies are also less levered than broadly syndicated loan obligors.
He adds that while leverage ratios have risen over the past 10 years from around four times levered to five times, it is less than broadly syndicated loan obligors, which have seen leverage ratios rise on average from five times to seven times.
The problem for some investors is with the SME collateral itself, with smaller companies often greater risks than larger corporates. However, Koenig says data does not always back up this assumption and both Moody’s and S&P show fewer defaults and higher recovery rates for the middle market.
