Asset owners are increasingly allocating capital to collateralized loan obligations, and with good reason, according to recent research.
Collateralized loan obligations — or CLOs — have produced outsized returns for investors who have allocated to the equity tranche, according to a study from Larry Cordell at the Federal Reserve Bank of Philadelphia and Michael Roberts and Michael Schwert at the Wharton School, University of Pennsylvania.
“CLO equity exhibits a great deal of resilience to market volatility, with the best-performing vintages issued just prior to the financial crisis,” the paper said. “Similar resilience is observed during the first year of the Covid-19 crisis.”
Pension funds have taken note of this dynamic, pouring capital into the asset class in 2021.
For instance, in March 2021, the State of Michigan Investment Board allocated $100 million to Kayne Anderson’s CLO Partners Fund II, which invests in CLO equity managed by Kayne and outside firms.
Meanwhile, in July 2021, the Rhode Island State Investment Commission transitioned assets out of master limited partnerships and real estate investment trusts and into CLOs, citing market conditions.
And in October, the Teacher Retirement System of Texas set up a new leveraged loan investment fund platform alongside CIFC Asset Management.
“The interest from pension funds, various insurance companies, and other pools of capital has grown because I think that the asset class has historically been less understood and people were perhaps concerned with the mark-to-market volatility,” said Deep Maji, senior managing director at CLO equity specialist Oxford Funds.
CLO equities tend to have volatile valuations, which, according to Maji, has turned off investors in the past. But, he added, long-term investors like pension funds have started to see that this day-to-day volatility in valuations doesn’t affect the asset class’s returns.
“Historically CLOs were often conflated with CDOs which were a big driver for the Great Financial Crisis,” Maji said. “People just assumed that anything that started with a C and ended with an O was a toxic asset.”
But Cordell, Roberts, and Schwert showed through their research that this isn’t the case.
According to the researchers, this resilience persists because of the closed-end financing structure of CLOs, which keeps equity investors protected from capital outflows and rollover risk.
The researchers found that the average completed CLO equity investment offers a net present value of 66 cents per dollar invested, net of fees. That’s about $33 million or 6.6 percent of total assets per deal.
To determine this, they assessed 2,216 CLO deals primarily using data from Intex Solutions that was supplemented by information from IHS Markit, Morningstar Direct, Bank of America Merrill Lynch, and Bloomberg, among other sources. The dataset covers August 1997 through March 2021 and includes three “distinct business cycles” including the financial crisis and the first year of the Covid-19 pandemic.
While they noted that the average CLO manager isn’t better at choosing loans than their peers, some managers do tend to regularly outperform others.
“The level of dispersion between various managers can be pretty dramatic for any year,” Maji said.
According to the research, the median CLO equity measured had an internal rate of return of 11.56 percent. Those in the top 25 percent had a 17.8 percent IRR, while those in the bottom quartile posted a 4.59 percent IRR on average.
“I think CLO equity is one of the few asset classes in fixed income where you can really generate alpha based on your views and the way you construct your trades,” Maji said. “The reason for that is because the market is still fairly inefficient. It lends itself well to specialists who are in the trenches every day.”
