CLO supply outstrips demand
Do reports of a growing wariness over collateralised loan obligations (CLOs) mean that the good times are over for the investment vehicle? There are indications that supply may be exceeding demand as potential buyers take heed of warnings from the International Monetary Fund (IMF) and the Bank for International Settlements (BIS)over recent months.
- CLO supply exceeds demand, causing an increase in spreads
- Banks are able to increase loan rates and conditions as a result
- Many experts are warning of the danger of increased defaults in the underlying loans
- Professional investors are responding by focusing on better loan quality and larger-cap borrowers
CLO analyst and data provider Leveragedloan.com has warned that “the market could experience further indigestion, which was already witnessed pre-summer”. Banks discounting loans and tightening covenants are all plus points for investors, and may be positive for those investing in newer loans.
Several recent loans have been discounted to investors. For example, JPMorgan was reported to have unloaded a loan financing the takeover of private jet charter company XOJET at 93 cents on the dollar last December, with the borrower also having to increase its interest payments.
The average spread for AAA-rated new broadly syndicated loan CLOs widened to 122bps over Libor in November from 100bps in March, according to Bloomberg. “I don’t know if these are translating into a reduction in demand,” says Michael Kagawa, senior analyst at US asset manager Payden & Rygel: “There has been an increase in spread, but market demand is still pretty healthy.”
Eric Verret, head of corporate loans at NN Investment Partners, says the Dutch fund manager is active in the CLO market, “typically investing up to BBB grade tranches, with some allocation by individual name, mainly restricted to Benelux”.
So what is behind the concern? At first glance, CLOs have a lot to recommend them. They are portfolios of leveraged loans divided into tranches differentiated by risk, managed in the form of a fund. Investors have the benefit of getting diversified exposure to debt instruments linked to rates, giving them a measure of income protection in a rising-rate environment. Currently, CLOs have been taking up 60-70% of new leveraged loan issues.
The advantage for investors is that they provide a high degree of diversified exposure to leveraged loans, by both issuer and industry, along with a degree of protection via coverage ratios, with about 60% of a CLO being AAA-rated.
What is more, CLOs are not some whizzy new financial instrument – their record in the global financial crisis (GFC) was much better than the sub-prime-based CDOs, the implosion of which was the harbinger of wider market collapse. Since 1994, AAA and AA-rated CLO tranches have never defaulted, while cumulative default rates further down the capital structure were considerably less than 1%, according to S&P.
CLOs launched since the global financial crisis – dubbed CLO 2.0 – have more conservative capital structures. There is typically a shorter reinvestment period of four to five years compared with six years for CLO 1.0 and more stringent collateral eligibility requirements, which limit the CLO manager’s ability to invest in riskier assets.
“We’re currently happy to invest down to BBB-rated tranches” - Tim Crawmer
All of which should bring investors cheer. Between 2015 and 2017, the US CLO market nearly doubled in size to over $400bn, with a smaller European market at €75bn. Full-year 2018 issuance is set to beat 2017’s record of nearly €20.91bn.
Until recently, the CLO market was losing momentum, partly as a result of tightening by the US Federal Reserve. However, in contrast, there is a growing awareness that the credit cycle is becoming protracted, and investors may need to pull back their exposure as defaults rise – especially for lower credit quality, highly leveraged companies whose loans comprise a large proportion of CLOs.
This is something that the BIS specifically alluded to when it warned: “As business cycles mature… investors may start to incur losses.” At the time, the default rate of US institutional leveraged loans had increased from about 2% in mid-2017 to 2.5% in June 2018.
BIS further warned that CLO “mark-to-market losses could spur fund redemptions, induce fire sales and further depress prices. These dynamics may affect not only investors holding these loans but also the broader economy by blocking the flow of funds to the leveraged credit market.”
Diversification might offset some of this, with portfolios containing hundreds of loans across a wide range of sectors. Tim Crawmer, global credit portfolio manager at Payden & Rygel, says diversification can offset idiosyncratic risk: “Of, say, 100 to 150 loans in a CLO, there may be 5-10% we have some issue with. But high levels of diversification and protections such as overcollateralisation give comfort, and we’re currently happy to invest down to BBB-rated tranches.”
Another way of mitigating risks is to seek out higher-quality loan portfolios. Fiona Hagdrup, director of leveraged finance at M&G, says the firm invests largely in the large-cap, senior part of the market. This, she says, is “based on the simple fundamental belief that bigger companies are often those that will prove to be more resilient in a downturn, that they will have a ‘reason to exist’”.
CLO manager experience is also key. Kagawa says Payden & Rygel looks closely at managers’ CLO 1.0 track records in the selection process.
While the immediate effects of oversupply may be positive for investors, the imposition of stronger covenants could cause a reversal further down the line. One of the reasons why CLOs were so resilient throughout the financial crisis is that indebted companies had enough room to allow them to service their loans. The imposition of tighter lending criteria could result in higher defaults and lenders filing for bankruptcy when business conditions worsen. And, as monetary policy normalises, warned the BIS, the feature that has made CLOs attractive – floating rates – could trigger defaults by worsening borrowers’ ratio of net operating income to debt service costs. This could be further exacerbated if the borrower’s credit ratings declines, increasing refinancing costs.
“Do I see the world coming to an end?” asks Kagawa: “Far from it. This is, after all, an investment vehicle that has been tested through many cycles. It’s all good for the time being but we diligently watch for changes in default rates and in the wider economy.