Asset-backed loans: An approach that works in today’s uncertain markets

As interest rates have climbed this year, investors have been tempted by the higher yields now available on collateralised loan obligations.

Guest comment by Andre Hakkak of White Oak Global Advisors

CLOs represent a large, liquid market and their track record is well known. But in the current environment – with the highest inflation in 40 years, the uncertainty caused by the Russian invasion of Ukraine and a heightened risk of economic downturn – investors might want to consider a different loan product: asset-backed loans.

In today’s market, these loans can deliver solid returns and a level of security that will let investors sleep at night. Compared with CLOs, they offer numerous distinct advantages.

Asset-backed loans are often backed by collateral whose value rises with inflation. They are tied to hard assets – trucks and buses, aircraft engines, servers and equipment. These hard assets have generally climbed in price in an inflationary world. Effectively, they are hedges against inflation.

That is true whether the collateral is evaluated as an intact asset – say an aircraft engine – or whether it is calculated using a sum-of-the-parts analysis. That same engine contains metals such as copper, cobalt and titanium that have appreciated significantly. A good lender will perform both types of analyses before making a loan. The rising value of the collateral can give asset-backed loans an added measure of security in today’s world.

CLO vulnerability

Asset-backed loans are less sensitive to changes in economic conditions. CLOs, by contrast, are directly linked to the cashflows of the companies borrowing money and those flows can deteriorate quickly in an economic downturn. As central banks in the US and elsewhere hike rates to fight inflation, the odds of a recession increase. The pressures on companies can be even greater if the downturn occurs at a time of rising costs and rising rates. Simply put, three bad things can happen to businesses: their revenues can fall, their operating expenses can climb and the cost of their debt can increase. That triple whammy can translate to higher default rates and diminished returns for investors.

Asset-backed loans are less volatile and come with fixed rates, typically three to five years. That translates into lower price volatility. CLOs, by contrast, are floating-rate products, with prices that can move in a wider range. The loan structure of asset-backed loans offers another advantage. The loans can amortise faster than the underlying assets depreciate, which means that with each passing year, there is more collateral behind the loans. Again, another important measure of security.

The asset-backed loans market is not as large or liquid as that for CLOs, but a growing number of lenders, including brand-name private equity firms, have entered the business. The best ones offer funds with a broad package of loans that are well-diversified, both by industry and by the type of collateral backing the loans.

ABL was not created for the economy of today. It makes sense in most economic conditions. But in the current climate of stubborn inflation, heightened risk of a downturn and geopolitical uncertainty, its advantages are particularly compelling. Investors looking to de-risk their private credit portfolios would do well to consider adding these loans. They can offer a blend of attractive yields and downside protection. They may not be as high-profile as CLOs, but in this case, the road less travelled may be the better road to take.

Andre Hakkak is co-founder and chief executive officer of White Oak Global Advisors, the US-based SME-focused fund manager