Piyasi Mitra delves into the allure of collateralised loan obligations (CLO), spotlighting their diversification benefits and intricate structures.
In 2021, specialist asset managers created over $500 billion in CLOs, benefiting from substantial post-pandemic monetary support. However, momentum slowed in the first half of 2023, with only about $69 billion launched or refinanced, a 41% drop compared to the same period in 2022, as per JP Morgan data.
Hedge funds, insurers and asset managers, attracted by the higher yields in low borrowing costs environments, show a strong preference for these financial instruments. They make up 60% of the demand for single B-rated or lower junk loans, as reported by S&P Global Ratings. Experts explain what sets this market apart.
“Improved liquidity dynamics”
Paul Saint-Pasteur, global fixed income portfolio manager at Payden & Rygel, explains that securitised products like CLOs offer diverse exposure to various collateral types. Each tranche in the capital structure offers distinct risk, return and liquidity profiles, allowing for tailored portfolio customisation.
“Securitised bonds typically offer a higher yield per unit of credit rating than many other bond sectors and thereby provide a higher level of income relative to similarly rated asset classes,” says Saint-Pasteur. Additionally, securitised bond prices are typically less correlated with the broad fixed income market and can provide enhanced diversification benefits, he says.
“Securitised bonds typically offer a higher yield per unit of credit rating than many other bond sectors and thereby provide a higher level of income relative to similarly rated asset classes.”
Saint-Pasteur explains that since the global financial crisis, the landscape of structured products and CLOs has significantly evolved. Increased regulations have improved transparency in the asset class and facilitated more effective risk evaluation for investors. The asset class has expanded, and liquidity dynamics have improved.
However, Saint-Pasteur cautions investors to carefully evaluate the collateral, the structure of the deal, the quality of the manager or the platform managing/issuing the deal, the liquidity profile of the deal, and the regulatory framework governing it.
“A comprehensive assessment of the risks would also require scenario analysis/stress testing to evaluate the performance and liquidity dynamics of the structure under various environments, considering central scenarios as well as tail-risk events,” adds Saint-Pasteur.
“Structural complexity”
A CLO consists of several debt tranches, ranked according to the creditworthiness of the underlying loans. Jeffrey Stroll, chief investment officer at asset manager Post Advisory Group, highlights that 95% of CLO debt is floating rate, which provides a good interest rate hedge compared to the mostly fixed-rate exposure of high-yield bonds.
“CLO mezzanine notes (BBB/BBs) have also typically provided a yield pickup against high yield bonds due to their perceived structural complexity and a wider lack of familiarity with the CLO product,” adds Stroll.
“CLO mezzanine notes (BBB/BBs) have also typically provided a yield pickup against high yield bonds due to their perceived structural complexity and a wider lack of familiarity with the CLO product.”
Consequently, CLOs can provide a diversification benefit to high-yield bond portfolios through exposure to credit names outside a firm’s scope. “Moreover, CLO BBBs are typically structured with 12% credit enhancement while BBs have 8%. This provides protection against any underlying portfolio defaults or losses and creates a low probability of losses compared to idiosyncratic defaults in single name high yield bonds,” he adds.
CLO mezzanine tranches are trading at discounted prices, presenting benefits when held in bond funds, but challenges exist. The leveraged loan market, heavily influenced by CLOs (with 70% of their buyers), is experiencing heightened volatility. Worryingly, this volatility may significantly impact the CLO market. Additionally, regulators are scrutinising CLOs and their associated risk-based capital requirements for banks and insurance companies, potentially impacting demand for investment-grade tranches among these participants, explains Stroll.
“Due to the floating-rate coupon of CLO debt tranches, any significant moves from the Fed could lead to increased selling of floaters in favour of fixed-rate, investments,” he notes.
“Due to the floating-rate coupon of CLO debt tranches, any significant moves from the Fed could lead to increased selling of floaters in favour of fixed-rate, investments,”
Customised exposure
Andrew Bayerl, investment director at Wellington, shares his observations about clients using senior tranches (AAA-, AA- and A-rated to an extent) as a high-quality diversifier and income enhancer relative to investment grade corporates or cash. He observes that clients are increasingly using lower-rated and higher-risk tranches, such as BBB-, BB-rated and equities, to diversify their investments in high-yield, bank loans, emerging markets debt – and recently – private credit.
“A primary difference of CLOs relative to other traditional forms of credit is CLOs are floating rate,” he adds. This ties the CLO coupon to the SOFR short-term rate, resulting in CLOs having minimal interest rate duration. Bayerl cautions: “In an environment with elevated short-term rates, it has become an attractive option to some investors because the all-in yield is high. However, investors should consider their view on the path of interest rates.”
“In an environment with elevated short-term rates, it has become an attractive option to some investors because the all-in yield is high. However, investors should consider their view on the path of interest rates.”
Historically, CLOs have provided income advantages compared to similar-rated credit assets, allowing investors to enhance portfolio credit quality and increase overall coupon yields in a high short-rate environment. Bayerl notes that CLOs also provide diversification from corporate credit and equities. They have a lower return correlation, potentially enhancing risk-adjusted returns across a credit cycle.
The range of risk and return profiles across the stack makes CLOs a versatile tool. Yet, clients seeking liquidity should note that CLOs have lower liquidity than government bonds and, at times, lower than corporate bonds.
“Relative stability”
According to Krishan Padhiar, portfolio manager of structured credit at M&G Investments, adding CLOs to fixed-income portfolios can appeal to investors seeking diversification and reduced duration amid expectations of a “higher-for-longer” rate environment and heightened geopolitical concerns in financial markets. In addition to their floating-rate nature, one of the key features making CLO AAA paper attractive to mark-to-market sensitive fixed income investors is “relative price stability”, he says.
Euro investment grade credit outperformed CLO AAA and AA paper up until early 2022, cites Padhiar, but then suffered steep losses as duration sold off sharply when major central banks kicked their rate-hiking cycles into high gear.
The CLO market is trading at low levels due to exaggerated concerns about increasing defaults, which do not align with economic fundamentals. “While Europe’s growth shows some signs of weakening, CLOs still provide ample structural protection, keeping default and downgrade risks manageable,” says Padhiar.
What to expect
According to Bayerl: “We expect lower new issuance, similar to the dynamics in the US, which could tighten spreads due to the lower supply of bonds. This is balanced with the fundamental backdrop of expectations for higher downgrades and defaults in the loan market due to slowing global economic growth.”
Padhiar observes that in the current environment, investors are more selective. This selectiveness has led to cleaner portfolios outperforming as dispersion and tiering among CLO managers have risen. He anticipates that this trend will persist. “We identify opportunities in post-reinvestment period junior CLO portfolios, which are in the amortisation phase, experiencing credit enhancement improvements, and witnessing bond rating upgrades,” shares Padhiar.
“Additionally, CLO equity holds value, especially in the context of significantly repriced European loans, where deals with extended reinvestment periods and low locked-in capital costs generate high cash distributions.”
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