Strategies examined: CLOs

Faced with a daunting set of challenges, the collateralised loan obligation market appeared to be heading into a difficult year in 2017. Instead, CLOs have proved more resilient than analysts expected, as managers found ways to deal with each new roadblock and investors continued to find relative value in leveraged loans.

By September, CLO issuance in the US had hit an estimated $75 billion, passing the $72 billion total for all of 2016. Assets under management are now $460 billion for US CLOs and €70 billion for European CLOs.

“Investors have money they need to put to work, and CLOs do offer some value relative to other asset classes,” says John Nagykery, an assistant vice-president at Morningstar Credit Ratings responsible for CLOs. And there is no sign of a let-up yet as analysts predict volume could reach $80 billion-$90 billion by year-end. While that would be well above 2016, it is still far below the recent peak of 2014, which surpassed $120 billion. But in addition to new issues in 2017, CLO activity has received a boost from a wave of refinancing and re-sets.

“This has been a banner year to refinance existing CLOs,” says Christopher Acito, founder and CEO at Gapstow Capital Partners, a New York-based credit investment firm that both allocates to CLO managers and directly invests in CLOs. “That has accounted for a large percentage of activity in the CLO market.”

Indeed, the amount of CLOs refinanced through early September hit an estimated $85 billion, with another $36 billion undergoing re-sets. The robust dealflow in CLOs has overcome several roadblocks. Energy and commodity prices plunged at one point, threatening business loans that are part of CLOs and raising worries about a wave of defaults. New regulations mandating that CLO managers take equity stakes in new CLO issues took effect, potentially making it more difficult to issue CLOs or refinance those dating from when the new risk retention requirements kick in. And spreads tightened, reducing yields for investors.

But the energy and commodity drop proved less damaging than expected. And while tightening spreads hurt, CLOs still appeared attractive on a comparative basis with other investment options that have also been affected by historically low interest rates.

DIGESTING STAKES

One of the more surprising twists has been the ability of managers to meet the new regulatory challenge. New rules in Europe and the US require CLO managers to hold an equity stake of about 5 percent in new deals. Initially, there was concern that managers would have a tough time finding the capital needed to meet the requirement.

“Historically, asset managers weren’t capitalised to buy 5 percent of every CLO,” says Hiram Hamilton, global head of structured credit at New York-based Alcentra Group, an asset manager focused on corporate debt. “There was an adjustment period where some of the smaller, independently owned managers did have to sell to larger players.”

But the shakeout has not been as significant as many predicted. The number of CLO managers shrank from about 120 to around 85. But after that initial wave of consolidation the decline in numbers stopped as remaining managers figured out how to deal with the risk retention requirement.

As for raising risk retention capital, managers developed several ways to meet the requirements. While some larger managers had enough capital to handle the requirement internally, others turned to new risk retention vehicles that raise capital in partnership with investors.

These new vehicles have not only helped meet risk retention requirements, but also attracted large institutional investors that may not have been interested in CLOs before. Pension funds, sovereign funds and other significant investors, particularly those in Asia and the Middle East, have been attracted to the new risk retention offerings, which provide a way for them to make large CLO investments (often as much as $100 million-$200 million) alongside managers.

“We have been surprised at how much risk retention money is being raised,” says Volkan Kurtas, founder and managing partner of DFG Investment Advisors, a New York-based alternative credit manager focused on investing in the equity and debt tranches of CLOs as well as leveraged loans via CLO vehicles. “Risk retention sort of opened CLOs up to a different, larger, more traditional investor base.”

Resolving the risk retention issue has enabled a steady flow of new CLOs to come to market this year. Among the largest recent issues tracked by Thomson Reuters/Lipper was a $1.1 billion CLO in July by Ares, an $814 million issue by CIFC in August, a $652 million August deal by Brigade Capital Management, and two issues of $613 million each in August by THL Credit and GSO Blackstone.

A related risk retention issue helped fuel the refinancing surge. The US Securities and Exchange Commission issued a ruling that risk retention would not be required for refinanced CLOs with a vintage of 2014 or older. Refinancing newer vintage CLOs would require risk retention. The ruling prompted a surge of refinancing for the large batch of 2014 CLOs.

While transaction flow in 2014-vintage CLOs has been brisk, the opportunity may run its course soon. Acito estimates that as many as three-quarters of the CLOs that could be refinanced without risk retention have already been done.

One ongoing concern with CLOs is the strength of the underlying loans. When oil prices dipped below $30 a barrel in early 2016, CLOs with more loan exposure to the energy business were negatively impacted.

While the market was digesting the energy price drop, other uncertainties came into play, including concerns about spreads and interest rates, and the impact of risk retention requirements. It all combined to give the CLO market a temporary setback. For example, structured credit hedge funds that focus on CLOs reported negative returns every month from July 2015 to February 2016, ranging from minus 1 percent to minus 2.6 percent, according to eVestment, a data and analytics provider.

BOUNCE-BACK

But CLOs have bounced back, helped by a recovery in oil prices, the refi boom, and the solution to the risk retention requirement. As concerns receded, CLO-focused hedge funds returned to positive territory, with just one month of negative returns from March 2016 to August 2017, and that was a modest minus 0.2 percent in May 2016.

Hamilton says while default rates are always an important consideration with CLOs, the market is not pricing in much default risk. That could change quickly, though. “If oil went back to the $30s, the concerns would return,” Hamilton says.