Markets are a long way off the lows they hit at the end of last year but that doesn’t mean the worries have gone away. All the big US banks reporting this year faced a grilling from analysts on their leveraged loan exposure; UBS even added an extra slide to allay concerns. Senior regulators are lining up to warn of the dangers lurking in the market; top markets newspapers are running “leveraged finance for the layman” explainers in anticipation.
In all this, the collateralised loan obligation (CLO) market often takes a lot of stick. The Bank of England compared leveraged lending to US subprime on the grounds both were fuelled by rapidly growing securitization markets. The Bank concluded that the markets are different (and CLOs far less deadly), but it still saw fit to draw the comparison.
Some of those comparisons are simplistic and reactionary — there is no faster way to annoy a CLO manager than to enquire innocently if their product is “like a CDO” — but there’s some truth in them regardless.
CLOs, fundamentally, are just a tool to put more leverage on pools of leveraged loans (managers prefer calling them “secured loans” or “corporate loans”). More leverage means less equity is required to purchase more loans. Small allocations to the asset class can be magnified by nine times, while regulatory victories, like the end of US risk retention, mean managers see little downside in raising new vehicles. The music is playing, so managers keep dancing and the CLO bid accounts for, best guess, at least half of leveraged loan demand.
Raising new CLOs is tied to leveraged loan supply — if an insufficient volume of new loans comes to market, the spread between CLO liabilities and CLO assets will grow too small to make returns attractive — but there’s also a demand side driver, which has kept managers wading in.
For Japanese banks seeking triple-A rated dollar and euro exposure, senior CLO tranches have been the investment of choice, with far more juice on offer than Bunds or US Treasuries, floating rate coupons, and exposure to a broad range of US and EU corporate risk. This bid has anchored senior CLO tranches, and given managers confidence to keep coming to market.
Sophisticated critics point to the structure of the vehicles themselves. Having raised the debt tranches of a CLO, a manager is more or less forced to buy loans until the vehicle is fully invested, or performance is killed by the margin between cash and CLO liabilities (worse in Europe, where cash returns are negative). If sponsors show up with lousy covenants or aggressive offerings, CLO managers must buy anyhow, or scratch around in the secondary market for small, expensive clips of loans.
Thus, the argument goes, the presence of an active CLO market puts the power into the hands of private equity sponsors, who abuse it to push unnecessarily aggressive terms on innocent investors. When it all comes crashing down, people will lose money — without the early warning systems provided by financial covenants, which have all but disappeared in syndicated markets on both sides of the Atlantic.
But the same structural argument runs the other way. If something triggers a real collapse in leveraged loan markets, leaving banks stuck with hung bridges and loan funds pulling on their horns, the CLO vehicles are exactly the buyer base that’s needed to stabilise the slide.
The mechanics of ramping up a CLO vehicle over several months, combined with the multi-year term leverage priced CLOs have available, mean that out of the entire buyer base for leveraged loans, CLOs are the strongest members — the best able to bargain-hunt in a bombed out market.
A newly priced CLO doesn’t need to hand cash back to debt investors for perhaps six or eight years, and can buy new assets for three or four, far longer than the hold period any investment bank trading book would consider. Listed leveraged loan funds have to contend with withdrawals and forced selling. Only CLOs can hang in there and take a long term credit view, or use their stable funding structure to deliver big returns.
Last crisis, this played out, although many players in structured credit had other things on their mind. Unlike the mortgage deals or CDOs priced in the peak boom years of 2006 and 2007, the CLOs of this vintage tended to outperform, with stonking equity returns of up to 25%. That’s because they were still in their reinvestment periods, and were ready and able to sift around for bargains. LBO financing banks found themselves stuck with huge bridge books in 2007 and 2008 and with no natural bid in the market as credit conditions around the world contracted. But for the buyers that were out there, this was a great opportunity.
So far from being the villains of the piece, a market thick with CLOs is a market with awash with buyers of last resort.