The case for collateralised loan obligations

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22/02/2017

When I speak to clients around the world, including super funds and institutional investors across Asia, one of the first points I need to address is distinguishing collateralised loan obligations (CLOs) from other asset-backed securities (ABS). During the financial crisis, reports tarred CLOs with the same brush as other ABS but, in fact, CLOs demonstrated solid performance through the cycle, with low average loss rates across the rating spectrum.

I will now clear up some facts about this oft-confused asset class. CLOs are a repackaging of sub-investment grade (IG) corporate debt, offering investors access to a diversified portfolio of corporate credit exposure. They are mostly backed by private debt in the form of corporate senior secured, first lien floating rate loans with limited exposure to high-yield bonds. CLO returns are driven by the difference between the cost of debt and the yield the pool of loans generates, net of any gains or losses on the portfolio.

Attractive for diversity

Furthermore, CLOs are backed by first lien loans to large-market leading businesses, typically owned by sophisticated private-equity firms and with revenues in the hundreds of millions or billions – a far cry from the sub-prime mortgage borrower that supported some of the residential mortgage-backed securities (RMBS) and collateralised debt obligations.

With two-thirds of institutional investors worldwide saying it is essential to invest in alternatives to diversify portfolio risk, we believe CLOs are an effective diversifier. They are attractive to Australian institutional investors seeking current income, as they pay out regular distributions.

CLOs have enjoyed a resurgence since 2011 in the US and since 2013 in Europe, with record post-crisis issuance volume in 2014 of $143 billion, nearly surpassing the $144.2 billion recorded in 2006, Standard & Poor’s reports. In 2016, many new buyers entered the market. For new and longstanding investors in this asset class, the case for CLO debt is straightforward: it offers higher yields, for a given rating, than corporate credit. The yield premium exists due to the product’s complexity and lower liquidity. These debt tranches also benefit from asset subordination and coverage tests, which protect the debt tranches if the portfolio suffers downgrades and defaults. Overall performance has been good, with historically only a 0.7 per cent cumulative 10-year loss rate for US CLO IG tranches since 1993, Citi Research has found. The investor base is becoming more global, with a pick-up in demand from Asia in particular. The chart shows data from Citi revealing which investor types are active buyers of the CLO capital structure in the US.

Opportunities in Europe

Other ABS products, such as RMBS and consumer loan securitisations, tend to have thousands of underlying obligors. Compare this to CLOs, which have far fewer underlying obligors – typically 100-150 individual corporate loans. This means CLOs are more idiosyncratic and the performance of the junior tranches can vary with the performance of a small number of loans.

In the year ahead, we see opportunity in European CLO equity, which benefits from low financing costs. A low default environment in Europe in leveraged loans and the high cash pay nature of junior tranches of CLOs also support our view. In terms of risks, we are vigilant with regard to the potential for further European political instability and the impact this could have on default rates.

In the US, we remain watchful of the retail sector, where we expect further defaults despite an improving economy. We also remain cautious on the healthcare and technology sectors, where policy choices, in the case of the former, and consumer choices, in the case of the latter, could cause issues for some of the credits in the leveraged high-yield space. With optimism on what new fiscal policies US President Trump’s regime may bring, we believe US mezzanine and junior CLO tranches are priced too tight and will look for a lower entry point.

Finally, we see opportunity in the US and European Senior CLO (AAA) tranche space, for banks and pension funds seeking both downside protection and yield. The number of buyers of high-grade CLO paper continues to increase, with new entrants across the globe seeking more attractive returns from similarly rated investment-grade debt.

We believe in order to invest successfully in CLOs, you need to have a credit view on each underlying loan within the portfolio. As one of the largest global credit firms, Alcentra manages about US$17 billion ($22.2 billion) of leveraged loans globally and employs more than 30 credit analysts across its credit strategies. For any given CLO, Alcentra will typically be a lender to about half of the underlying companies. This, combined with our look through/bottoms up approach, gives us an edge when determining the proper value of specific tranches.



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