The collateralised loan obligation (CLO) market has a long history of delivering compelling relative value and total returns for investors.
While the origins of the CLO market can be traced back to the late 1990s, it wasn’t until after the 2001/2002 recession that the CLO market really began to flourish. The recession in the early 2000s proved that collateralised bond obligations could not withstand the double-digit defaults and anemic recovery rates that characterised their underlying collateral – senior unsecured bonds. CLOs, by contrast, benefited from their exposure to a diversified pool of senior secured loans that exhibited higher recovery rates.
In 2008, long-term, locked-up financing that was not subject to market value triggers allowed CLO managers to retain their portfolios while many other market participants were forced to sell. Investment periods of up to seven years allowed CLO managers to actively manage their portfolios, trade for relative value and reinvest prepayments and pay downs in deeply discounted assets. Annualized prepayment rates for most portfolios remained healthy, which provided new cash to invest in attractively priced collateral.
Strong collateral performance, good structural protections and differentiated track records of select investment management platforms have made today’s CLO market an attractive option for many investors. A robust loan market with over $840 billion outstanding, according to S&P LCD, has allowed CLO managers to be selective and provide their investors with highly diversified, actively managed portfolios that often include over 200 individual loan issuers.
OPPORTUNITY FROM ADVERSITY
With significant regulatory changes only a little more than one year away, CLO managers are wrestling with the most palatable ways to comply with risk retention. Under the new regulations, CLO managers will be required to retain at least 5 percent of the deals they issue, straining balance sheets across the market. While managers were initially able to defer the issue of non-compliance (via shorter non-call periods), their ability to do so is quickly eroding. In its place, we are seeing increasingly concessionary structures as investors demand more compensation for risks associated with non-compliance. Just recently, we saw a number of deals in which the management fees step down should the deal be precluded from refinancing due to the manager’s inability or unwillingness to become compliant.
Realistically this trajectory will only accelerate further. As the regulation implementation date approaches, we expect the capital requirements to unambiguously limit issuance and further bifurcate managers. Managers with insufficient balance sheets will need to sell/wind down their operations, or make concessions to third-party investors for the requisite capital.
The curtailing of CLO issuance should create potential for the CLO arbitrage to improve, as wider loan spreads and tighter CLO liability spreads translate into higher excess spread and thus improved equity returns. In addition, risk retention is expected to provide opportunities for long-term investors to partner with CLO managers to help meet risk retention in return for higher expected returns via management fee concessions and favorable purchase prices from banks.
Risk retention’s effect will also play a core role in what we view as two interesting CLO trades today: investments in mezzanine debt and secondary CLO equity.
NEW MEZZ OPPORTUNITIES
We are constructive on opportunities to take advantage of the ebbs and flows of the CLO new issue market by investing in mezzanine tranches for total return.
Mezzanine spreads have widened substantially since the beginning of September, even as the credit outlook for non-commodity-related loans remains stable. Spread widening has primarily stemmed from a trifecta of factors, namely: market uncertainty surrounding the timing/impact of a Fed rate increase; equity market volatility; and commodity contagion fears. We believe these factors’ impact on the overall market will be relatively short-term in nature and expect mezzanine spreads to tighten in 2016. In addition, we believe that the risk retention regulations will notably slow new issue CLO formation in 2016, providing a strong supply/demand technical for mezzanine bonds.
While yields have gapped out as of late, allowing investors to generate 9 percent returns to maturity in many BB-rated CLO securities, we see opportunity in capturing spread tightening on these and other lower rated bonds within the CLO capital structure. Even a relatively modest retracement of the recent widening in spreads could generate mid-teen total returns for investors with an investment horizon of 6-12 months and the ability to withstand near term mark-to-market volatility.
SECONDARY CLO EQUITY
Similar to our view on CLO mezzanine notes, CIFC believes that current market conditions have created a compelling opportunity to build an attractive portfolio of CLO equity sourced from the secondary market. Our thesis mirrors that of our mezzanine view – that relatively short-term factors have depressed equity prices to attractive levels given the upcoming contraction in supply brought on by risk retention implementation. In particular, the current market environment is creating opportunities to purchase secondary CLO equity at levels that are expected to produce high-teens IRRs to maturity or 20 percent-plus IRRs in an early call scenario.
Augmenting this potential upside, there are multiple market participants including investment bank proprietary trading desks, hedge funds and business development companies (BDCs) seeking to reduce exposure to the CLO equity market, presenting an opportunity to capitalize on potential forced sellers.
Proprietary Trading Desks: Regulatory changes have made it capital inefficient for many banks to hold unrated exposures. As a result, many banks continue to reduce exposure to CLO equity.
Hedge Funds: Hedge funds have historically been one of the larger buyers of post-crisis CLO equity, but a combination of redemptions due to disappointing overall fund performance and increased volatility in CLO equity prices has caused many hedge funds to reduce their exposure to the asset class.
BDCs: The perceived complexity of CLO equity as well as questions surrounding the transparency of valuation practices have led investors to reduce their exposure to BDCs with high allocations to CLO equity. To help restore investor confidence, some BDC managers have started to reduce or eliminate new commitments and, in some instances, sell their existing CLO equity holdings. This market dynamic has curtailed an important source of demand, particularly for new issue CLO equity, and turned BDCs into a potential source of secondary CLO equity supply.
The ripple effect of risk retention’s impending implementation, as well as the likely composition of the subsequent market, presents a number of opportunities for well-capitalized managers to extract value.
If an investor has the ability to (re)underwrite CLO collateral pools on a granular basis, and understands how the market trades structure, basis and quality of manager platform, CIFC believes that the current market offers a compelling opportunity to produce differentiated total returns across both mezzanine CLO tranches and secondary CLO equity.