Secured Loan Obligations (CLOs) have fallen on hard times over the past two decades.
In 2004, the Luxembourg Parliament adopted the law on securitization in order to limit CLOs and to protect investors against taking on additional risks.
But on February 9 this year, Luxembourg pursued a new goal of rebranding the jurisdiction as a hub for CLOs – and changed legislation to allow active management of the asset class.
The decision is timely: last year, CLO primary issuances reached their highest levels since before the 2008 financial crisis, with 94 CLOs and 38.5 billion euros of notes valued, according to Fitch Ratings. .
The global CLO market is expected to reach $1.2 billion (€1.14 billion) by the end of 2022, and more than 500 bond funds currently have exposure to the asset class according to a Citywire analysis of Morningstar data.
But as the market has grown, its share of the second-lowest bracket, B-, which represents 26% of the S&P LSTA Leveraged Loan Index in January 2022, has also increased.
This is the highest proportion of B-CLOs on record, according to a Barclays report which claims the market is failing to price tail risk.
Adding to this concern is the fact that investors who previously targeted AAA-rated CLO tranches are increasingly turning to lower-rated tranches in search of stress-resistant returns, according to Dr. Nisha Long, head of ESG research and cross-border investment at Citywire. .
“There’s no point in getting into AAA or AA-rated CLOs because the risk profile is the same as investment-grade and high-yield companies,” Long said. “CLO BB and B are where the returns are, but also the huge volatility.”
While CLO AAA tranches have a 9.5-year annualized volatility of around 2.5%, the corresponding numbers for CLO BB and CLO B tranches are around 17% and 21%, according to PineBridge analysis. from Bloomberg, JP Morgan, S&L LSTA and data from Barclays.
This means that the annualized volatility of lower-level CLOs is significantly higher than that of high-yield corporate bonds, where the volatility is around 7%.
Despite this, Union Investment head of credit solutions Alexander Ohl (pictured above) says CLOs are, in fact, less risky than corporate bonds.
“CLOs are floating rate products, which protects them against the upcoming cycle of rising global interest rates, and they offer substantial spread increases over corporate bonds of similar ratings. – which can be seen as a premium for complexity and illiquidity, rather than risk,” Ohl said. Citywire Selector.
“In fact, the fundamental risks of CLOs are lower than those of corporate bonds. CLOs offer less credit risk and less interest rate risk than corporate bonds and are therefore an attractive alternative for institutional investors,” added Ohl.
Pim van Schie, rated A by Citywire, senior portfolio manager for non-investment grade credit at Neuberger Berman, has a similar outlook.
“The CLO structure is a cash flow structure. It is therefore specifically designed to be indifferent to fluctuations in the market value of the underlying loan portfolios and its performance is ultimately based on the credit performance of the underlying loans.
“Given the structural protections that investors enjoy by investing in CLO tranches, whether it is a triple B, a single B or a higher tier in the capital structure, the structural protections remain very important.
“Our view is that investing in CLO debt, from a credit perspective and from a fundamental perspective, is quite far removed from credit risk,” van Schie said.
However, not everyone sees the call of the CLO.
In the current yield environment, Kaspar Hense, rated AA by Citywire, of BlueBay Asset Management’s Investment Grade team, believes the high liquidity premium of CLOs is wasted.
“We think the risks there are very, very high,” Hense said. Citywire Selector.
“CLOs carry a high liquidity premium. It made sense at a time when yields were really low and you could lock in 7% five years ago. But locking in during low yields in this environment, which has changed drastically over the past month, is a little late for the party.
‘Massive downgrades? Unlikely.’
Although he noted that the large number of issuers that have been upgraded in the past 12 months could change if the economy weakens, Simon Matthews, rated A by Citywire at Neuberger Berman, does not envisage downgrades. massive.
Instead, Matthews (pictured above) said the rapid growth of the CLO market has resulted in a greater variety of sectors such as healthcare and software.
It’s diversification that has improved the defensiveness of the CLO market, Matthews said, despite the record proportion of B issuers.
Elena Rinaldi, portfolio manager on TwentyFour Asset Management’s asset-backed security team, agrees. “Massive downgrading of CLOs? Unlikely.
“We definitely expect default rates to rise as we could expect a recession in 2023 and rating agencies should tighten their methodologies. But we don’t expect that to have a significant impact on credit in CLO tranches,’ Rinaldi said Citywire Selector.
According to her, this is because CLO ratings already factor in negative rating migration and inflation-linked defaults.
“According to Fitch, the average downgrade cushion for a B-CLO is around 12%, which is higher than the 2009 loan market default rate.
“So if you consider next year’s default rate forecast could be 2.5-4%, it’s nowhere near that kind of level and you’re pretty well protected,” Rinaldi said. .
According to Rinaldi, the pandemic has already proven the resilience of CLOs as only 41 of the roughly 2,000 tranches rated by Fitch were downgraded one notch in 2020 – most of which were upgraded in 2021 due to performance and deleveraging.
Similarly, van Schie said the wave of downgrades in 2020 has “trimmed some of the excesses out of the lending market” and left current issuers well positioned to absorb the impact of inflation, rising costs and ongoing supply chain issues in 2022.
“That’s part of why we’re seeing default rates in Europe and the US near record highs,” Matthews added. ‘We see [defaults] steadily increasing a bit, but not at the rate you might otherwise expect.
Even if massive downgrades to CCC were to occur, van Schie said, investors are not obligated to sell.
“CLOs are generally allowed to hold up to 7.5% CCC loans. Even in 2020, when the CCC percentage of CLOs averaged around 12% in the US market, it did not cause a wave of forced selling.
“What you might see is that managers experiencing a large increase in the percentage of CCC loans in their portfolios may try to sell some CCC loans to keep their equity distributions flowing,” van Schie said.
Few steps needed
Van Schie’s Neuberger Berman CLO Income fund invests primarily in BB-rated and, to a lesser extent, B-rated tranches, which it considers distant credit risk.
“The primary risk of investing in CLO mezzanine debt tranches is the potential temporary volatility in the market values of the securities.
“As a result, we view these investments as only suitable for sophisticated institutional investors. Therefore, the fund does not have a retail share class,” van Schie said.
He added that the fund offers liquidity to investors fortnightly.
At TwentyFour, Rinaldi has an average of 5-10% cash in his public wallets, along with around 10% fast assets, to boost liquidity.
“But we don’t typically use cash to smooth out volatility,” she added. “We consider AAA CLOs to be high beta, although in the past they have been found to be more liquid than BBB CLOs, for example.”