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Cutting a tranche of yield

Despite a modestly improved investment landscape, the hunt for alternative sources of yield remains a huge challenge for pension trustees.  

However, there are asset classes available which, in certain forms, offer the potential to provide the strong, long-term liability matching cash flows highly coveted by pension schemes. One of these, although much maligned during the credit crisis, is structured credit.

This article examines the viability of two subsets of structured credit: collateralised debt obligations (CDOs) and collateralised loan obligations (CLOs).

CDOs and CLOs are both asset-backed securities linked to the returns and income from a pool of bonds and mortgages, or bank loans, respectively. Investors earn income in the form of interest payments and are subject to gains and losses as the underlying assets’ prices change and defaults occur.

CLO and CDOs can also be divided into tranches, whose entitlement to cash flows are determined by their seniority ranking.

Coupon payments vary by tranche with the most senior holder paid the least and the most junior paid the most, to compensate for the higher risk of default.

While growth in many developed economies like the UK has been sluggish, by contrast, company balance sheets and cash flows, and thus credit fundamentals in the corporate sector, tend to be strong. This is manifested in default rates, which are low in both absolute terms and relative to historical averages.

But what about liquidity? That certainly deteriorated over the financial crisis and this was reflected in market prices.

However, actual defaults were minimal and price falls within the representative index in 2008 were fully recouped in 2009.

Risks

A primary concern is naturally that of default. US default levels have twice risen to the 8% level within the past 15 years, according to data from Credit Suisse and S&P. The first time was around the technology bubble and subsequent downturn, and then again  during 2008-09.

These peaks were short-lived and the long-run rate is less than 5%. Even in default, Moody’s data indicate that recoveries in the US market have averaged around 70%, making long-term losses relatively small.

But when default rates have increased, so too have the spreads over treasuries, thus implying a meaningful mark-to-market capital loss.

Liquidity has also tended to dry up during these conditions. For this reason most providers have official ‘lock-up’ periods and the risk is that these come into force during periods of stress.

This is also likely to coincide with a poor equity market environment.

In short, CLOs and CDOs might offer high yields with a relatively small risk of permanent capital impairment but investors should be aware that they do not offer instantly redeemable liquidity.

CLO and CDO investments can be structured to deliver a range of target yields by creating tranches.

A CLO an investor can choose to be exposed, for example, to the first 10% of defaults on the underlying loans (high risk) or to be impacted only if defaults reach 11%-20% (low risk), or 21%-100% (very low risk).

In return for taking more/less risk an investor will receive a higher/lower income stream. A typical range of expected returns could be between 3% and 10% per annum.

Investments at the low risk/return end of the spectrum share the stable, medium to long-term cash flows of liability-matching assets, whereas investments at the upper end can be considered potential return-enhancement or growth-style assets.

 

Geoffrey Randells is director of client investment strategies at SEI Institutional Investors

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