“CLOs have proven to be resilient: leveraged loan secondary markets recovered quickly from the turmoil in March 2020, led by a rally in higher quality credits before extending to lower rated and covid-battered sectors beginning in 4Q 20”. This summary from FTSE Russell, the index specialist and subsidiary of the London Stock Exchange, speaks to the strong performance of the collateralised loan obligation market during the pandemic.
This resilience has come as something of a surprise to many. As FTSE Russell points out: “Many observers feared that complex-sounding products, with complex or opaque-sounding names, would be the first dominos to fall in a repeat of the systemic problems of 2008.” Of course, back then it was collateralised debt obligations causing many of the problems – a very different product with, unfortunately for CLOs, a very similar name. The two have often been misguidedly conflated ever since.
But whereas CDOs helped bring the markets crashing down, CLOs have emerged in good shape not just from the global financial crisis but also various energy crises and now the pandemic. Each time, Armageddon has been predicted by many observers and each time the CLO market has seen off the doubters and won over more investors.
What is the key to the market’s enduring success? CLO market participants point to the advantages of active management. Although investors buy into a pool of loans, that pool is not fixed as the CLO manager has the ability to buy and sell its exposures. This idea spooks some investors since it has ‘blind pool’ connotations – the portfolio you invest in at the beginning is not the one you end up with in the end. But what it gives the manager is flexibility and fleetness of foot that can prove crucial, especially in times of market stress.
When the markets became dislocated in the early months of last year, CLOs were not alone in having exposure to sectors badly affected by covid and, because of that, many suffered some degree of impairment and loss. But managers were able to seize on a buying opportunity, with loans made to high-quality companies suddenly available at significant discounts. It’s this active trading that has served CLOs well. One source told us that many CLOs took significant hits during the GFC but, by the time they came out of it, they were invariably in better shape than when they went in.
There has in fact been a frenzy of activity in the CLO market in 2021. Partly, this is attributed to investors wanting to put as much capital to work as possible before an expected pause next year as the market adjusts to the phasing out of the LIBOR benchmark. But it’s also testament to something else: the CLO market’s ability to keep defying the sceptics.
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