Worth a second look – senior tranche CLOs

Put simply, the CLO investor base is broadening for a wide variety of reasons. The newest entrants, pension funds – along with their investment advisors – are evaluating how to construct a fixed income portfolio that includes CLO opportunities as an alternative to more conventional, longer duration and lower yielding, public debt instruments.

A BRIEF HISTORY OF EUROPE AND THE US – THE CLO CUT

To understand why CLOs are gaining greater investor attention from asset allocators, investors should consider the regulatory dynamics which have impacted the securitization market and directly impacted CLO issuance on both sides of the Atlantic. The European and US markets have not been immune from the pressures of political and regulatory change. The effect has shifted the nature of supply and altered the characteristics of buyer demand; to attract new entrants the most effective fix for this structural imbalance is price. This creates opportunity.

Between 2009 and 2013, the European ‘new-issue’ CLO market was effectively closed. In 2013, issuance gradually re-started and in the last 12 months there has been a growing volume of seasoned managers bringing new vintage transactions to market. As of the end of September, 24 non-US CLOs had priced $13.6 billion compared with 14 CLOs totaling $6.4 billion for the comparable period in 2013, according to JPMorgan data up to 30 September. Issuance in Europe has been at times impacted by investor sentiment, but it is regulation that weighs most heavily. Manager structuring retention rules, colloquially skin in the game, have hindered the ability of many pre-crisis CLO issuers to bring new transactions to market. Having sizeable capital committed within each transaction may reduce the number of active market participants. Whilst for others, whose capital base is deep and the investment platforms suitably diverse; it creates significant new opportunities for asset raising.

US regulation has arguably been even more extensive, although different in terms of impact on supply dynamics and buyers. Regulatory changes invoked by the Federal Deposit Insurance Corporation (FDIC) and more recent rulings on the Volcker Rule have left US CLO market prices wider than their European counterparts over the last 12-18 months. The FDIC changed their methodology for calculating deposit insurance premiums, which directly impacted banks investing in CLOs, reducing the appetite for senior-only tranches and leaving spreads elevated. In December 2013, following on the heels of the FDIC changes, the Volcker Rule implementation resulted in more stringent requirements for banks’ CLO holdings.

The new rules reduced the proportion of bank buyers in the broader CLO market, widening spreads across the entire capital structure of CLOs. This spread widening has resulted in new entrants, and not just pension funds, but insurance companies and asset managers evaluating the CLO opportunity. Whilst issuance and pricing in the CLO market are likely to ebb and flow as the market adapts to a longer-term buyer demographic, overall the evolving investor base has helped CLOs begin to gain acceptance as an investable asset class. This has already led to significantly improved market liquidity, a trend we expect will continue.

In terms of quantifying the premium available, a closer examination of the spreads in the CLO market shows that senior tranche investors are currently able to earn a substantial spread premium versus investment grade corporate, commercial mortgage-backed securities (CMBS), asset-backed securities (ABS) and European residential mortgage-backed securities (RMBS) (Figure 2). Specifically, investors in US CLOs have the potential to earn a spread premium of 129 bps at the AAA level, 209 bps at the AA level, and 291 bps at the single-A level versus similarly rated investment grade corporate debt.

CLOs spread premium over other asset classes

In addition to the spread premium on offer and their transparent structure, CLOs have also historically exhibited low default rates. In March, Wells Fargo produced research on the default history of CLOs showing that they have performed well on both an absolute basis and relative to corporate debt. For example, out of more than 6,100 CLO tranches analyzed over the period 1994-2013: Only 32 tranches or 0.52% defaulted during that timeframe.

No AAA or AA tranche ever incurred a default, and only 5 tranches at the A level and 5 tranches at the BBB level incurred default This track record of low defaults reflects the resilient performance of senior secured bank loans, the structural features embedded within CLOs, and the benefit of having a dynamically managed collateral portfolio.

WHERE DOES THAT LEAVE US?

We believe that senior CLOs have the potential to deliver for investors on many fronts. In a yield-hungry investment environment, the spread premium they offer can assist investors in reaching their portfolio objectives. Investors know from experience, however, that a yield advantage can evaporate quickly in the event of credit deterioration or, at the extreme, default. While these are risks that investors need to be aware of, it’s also fair to highlight the low default history of CLOs (absolutely and relatively) and the stronger structures that have emerged in recent years.

As a result, we believe that in today’s environment, a manager with entrenched roots in the CLO asset class, can offer long-term investors access to this overlooked asset.

COLLATERALISED LOAN OBLIGATIONS – THE LOW-DOWN

CLOs are in fact quite simple debt capital markets transactions. They are designed to pool a number of senior secured bank loans as the collateral asset and issue liabilities (bonds), to fund the purchase of the bank loan collateral. Figure 1 illustrates a typical cash flow CLO structure, from the senior tranches through to the equity.

Understanding CLOs

Bank loans themselves have many positive attributes. Senior secured higher yielding assets that are floating rate in nature provide a natural inflation and interest rate hedge, coupled with high recovery rates in the event of a corporate default. The collateral is increasingly familiar to many institutional investors in today’s asset allocation models, and its use in a securitization is a key to why the highest rated tranches are proving an attractive alternative asset choice.

CLO collateral pools are generally comprised of between c.100-150 individual senior bank loan issues. In this low corporate default rate environment, the result is a robust structure enhanced through a series of tests ensuring that the highest rated tranches, the senior bonds, are provided with first priority cash flow to service their liabilities. Given the collateral pool’s diversification and waterfall interest payments, investing in the highest rated senior bonds is well worth additional consideration.