Collateralised loan obligations are enjoying a period of rude health, characterised by active primary and secondary markets, product innovation and manager differentiation. Since the loan market is largely covenant-lite, we believe defaults are still some way off, though recovery rates may be below historical averages (chart 1).
Credit and equity markets are at, or have approached, all-time highs this year. CLOs, however, have lagged considerably, pushing spreads out to historically wide levels for many tranches, particularly in the lower part of the capital structure. In Europe, new issue single-B tranches are approaching 11 percent with LIBOR floored at zero – this is almost 4 percent wider than historical tights and without meaningful deterioration in portfolio quality.
CLO market history
Despite having been through the global financial crisis, the average 2006-07 vintage US CLO equity tranche generated returns in the mid-to-high teens. This underscores the robust structure of the CLO asset class: it is rules-based and those rules are designed to protect noteholders, particularly during times of significant market volatility (chart 2).
During times of stress – with increased defaults or downgrades on CCC-rated loans – CLO payment rules divert cash to pay down senior tranches or to buy more assets. Since their liability spreads may have been locked in during better market conditions, CLOs can also benefit from loan spread widening.
During the reinvestment period, managers can reinvest at wider spreads, thereby increasing the interest cashflow available to pay equity tranche holders. In extreme scenarios, cashflows to lower tranches may switch off and, when they switch back on, tranche subordination and equity distributions can be higher than previously.
Innovation for new market conditions
The creation of non-standard CLOs (also known as enhanced or high CCC CLOs) reflects the opportunity that may arise should B-/B3 loans be downgraded to CCC. Typical CLOs are permitted to hold up to 7.5 percent of their portfolios in CCC assets without affecting cashflows.
Any additional CCC loans beyond this threshold are treated similarly to defaulted assets (tests that determine whether cashflows to lower-rated tranches are subject to a haircut). CLOs with larger CCC bucket allowances (up to 50 percent) have emerged from specialist CLO managers looking to buy loans that have been downgraded to CCC.
Should there be a significant downgrading of loans by the ratings agencies, many standard CLOs and loan funds will be unable to purchase these loans. Consequently, there should be a divergence between the fundamental value of CCC loans and the prices they can command. There would therefore be an opportunity for these enhanced CLOs to buy CCC loans that may have been unfairly marked down because of the lack of a natural buyer base.
Another innovation relates to the mascot structure (modifiable and splittable or combinable tranches) of CLOs. In these structures, investors have the ability to split CLO debt tranches, post-closing, into principal-only and interest-only components. The aim is to allow investors to hedge and express views on the timing of the refinancing and resetting of CLOs. This is particularly important as the price and duration of a CLO’s tranches can vary significantly depending on the likelihood of the CLO’s ability to refinance and thereby extend the manager’s ability to reinvest.
CLO equity valuations
Analysing and valuing CLO equity depends on many factors, each of which can play an important role in its long-term performance. Among these factors are the initial arbitrage, the purchase price, the manager, the portfolio-weighted average spread, and the weighted average rating. It is crucial to analyse which factors are most significant, but it is equally important is to understand which plays a greater role at different junctures.
Furthermore, when evaluating managers’ track records, it is important to track par build/loss over time, rather than simply looking at the managers’ published default exposures. One way to do this is to look at the entire universe of defaulted loans and analyse how each manager behaved over time with them. Did a manager invest in a loan pre-default and then sell before distress started? Did they avoid it altogether? Did the manager purchase a pre-defaulted loan and hold it as the price fell, only to sell it just before default? Answering these questions requires detailed research but significantly enhances the analysis of how a manager performed for both the debt and equity sides.
Finally, when evaluating a portfolio of CLO tranches, it is critical to look at the overlap of loans in aggregate across the portfolio rather than simply assuming broad diversity. Loan overlap can be high, particularly within a given vintage or across a single manager’s CLOs.
Similar to the CDO of asset-backed securities phenomenon of 2007-08, investors may believe they are diversified across a large number of holdings only to discover there is a high correlation between their investments. Quantifying this overlap effect is fundamental to understanding the impact of idiosyncratic loan defaults.
It is understandable that investors are concerned about investing in credit, given the extended business cycle. Many will agree that we are in the late stages of the cycle. However, there is little consensus about when or if a meaningful pick-up in defaults will occur, the length of time this will take or how the next downturn will look when compared with the last one.
Given the lack of covenants and the longer-dated maturity profiles of loans (chart 3), this may mean we are still several years away from the next wave of defaults.
In the last downturn, equity investors taking a medium-term view of CLO performance emerged with attractive IRRs. Clearly, investors faced volatility throughout the recovery but, overall, CLO structures performed as they were designed to, and those with patient capital were able to benefit from the structural mechanics.
Given the further work performed by the market to make CLO structures even more robust and resilient to stress, we think it reasonable that attractive risk-adjusted returns can be obtained from one cycle to another.
Shawn Cooper is head of CLO portfolio management at Orchard Global Asset Management, an alternative asset manager focused on structured credit, speciality lending and opportunistic fixed income