The allure of structured credit

Institutional investors looking for sustainable double digit returns should look at the structured credit securitisation market. A diversified portfolio of collateralised loan obligations (CLO) securities can achieve attractive core returns in the 7-9 percent range and in excess of 12 percent if combined with equity and mezzanine investments in structured credit securities. Active trading can enhance returns further.

Specialist managers offer investment funds in CLOs or can construct managed accounts tailored to an investor’s risk return parameters and differing liquidity profiles. Such portfolios would fit well into credit, alternative, opportunistic or fixed income baskets for pension funds and insurance companies .

CLOs form part of the broader structured finance market that has, in many quarters of the political and financial system, been blamed as one of the principal causes of the financial crisis. However, within the structured finance arena, CLOs as an asset class have performed relatively well throughout the crisis, in the vast majority of cases returning interest and principal to investors of CLO liabilities in full. The mainstream negativity towards the asset class, combined with lingering doubts around the periphery, provides further opportunity for an investor to find value

The European Central Bank and the Bank of England are promoting the revival of the securitisation market, especially in the SME sector. Whilst the precise details of what securities will benefit from a QE approach is open to discussion, spread narrowing has happened and will continue. The CLO market in the US is booming with new issuance in 2014 to date of $80 billion. There have been over €8 billion in 2014 from zero issuance for a couple of years post 2008.

An investment in a CLO liability is executed by purchasing a CUSIP/ISIN security that appears on Bloomberg from a dealer at an investment bank. This security is secured upon the cashflows of an underlying portfolio of assets that have been selected by an independent asset manager subject to certain constraints including diversification and credit spread tests enforced by recognised rating agencies. In certain situations, an in depth knowledge of the CLO managers ability to manage the CLO is a crucial part of the investment process.

Within CLOs the underlying portfolio is European leveraged loans. European leveraged loans are typically the most senior debt obligation in the capital structure of the corporate entity and are secured on substantially all assets of that corporate group. European leveraged loans and CLO liabilities are broadly floating rate liabilities providing further protection for the investor against interest rate rises.

Furthermore, depending on your choice of seniority within the capital structure, the security purchased has a certain level of credit enhancement and structural protection based on the contractual structure of the CLO.

The security is a traded instrument too, typically settling three days after purchase via Euroclear in the usual bond method of Delivery Verses Payment (DVP). This brings an extra potential return as if an investment starts to perform ahead of market expectations an investor can capture this gain via selling the investment. Also if the investor’s view changes and becomes negative towards the investment, in normal market conditions the investor can exit their investment via a sale of the security. This method is usually very efficient in comparison to selling the underlying portfolio of loans which may take months.

Valuing CLO securities is not trivial but in most cases the majority of the value of the security purchased is driven by the value of the underlying portfolio combined with the structural features and credit enhancement of the security. With strong credit investment expertise, an investor can build a highly diversified portfolio of corporate risk, at attractive returns, that is robust to increasing interest rates and economic stress via the CLO market. Structured credit securities and in our view corporate CLOs offer sustainable value and a diversified approach to credit investing.