Are investors crazy — or cagey — to be buying collateralized loan obligations?
Insiders put the question in somewhat less stark terms: “I would term investing in CLOs controversial,” says Jack Yang, president of New York’s Credit Strategy Consultants and former vice chairman of the Loan Syndications and Trading Association.
What’s so controversial about this particular species of collateralized debt obligation — CLOs are fashioned predominantly out of corporate bank loans and in much lesser part out of high-yield bonds and equity — is that the CLO market remains severely disrupted postcrash. And investors burnt in that conflagration may no longer have the capital, or the cast-iron stomachs, to venture back into CLOs.
Yet this very combination of market upheaval and investor trepidation has created some exceptional opportunities for investors who are savvy — and brave. “People who understand CLOs can find securities that on a fundamental basis are outrageously cheap,” says Yang.
The lowest-rated CLO tranches — the equity portions — were yielding an amazing 40 to 60 percent in mid-March. That contrasts with 10 to 20 percent historically. Even the highest-rated (AAA) tranches, comprising senior, secured bank loans to companies, were offering 2 to 5 percentage points above their customary Libor benchmark, or five times their historical average.
Such striking deals have become available because the prices of CLOs fell much further than the prices of the underlying loans used as collateral. As of March 12, bank loans were trading, on average, at 88.5 cents on the dollar, compared with 98.5 cents on January 1, 2007, according LSTA/LPC Mark-to-Market Pricing Service.
For CLO tranches initially rated AAA, the pricing pattern was much the same; they were trading at around 88 percent of their face value. Precrash, though, AAA-rated CLO tranches might well have sold at a premium to their underlying loans, because the act of pooling the loans made for greater safety.
However, an A-rated CLO tranche backed by a pool of diversified senior bank loans might be mired today at only around 60 cents on the dollar. The potential pricing anomalies associated with the various CLO tranches are what make them so tempting today.
Mark Okada, chief investment officer and co-founder of Dallas-based Highland Capital Management, a leading CLO and alternatives fixed income manager, believes a 12- to 24-month window remains before the anomalies — and thus the good deals — disappear.
Nonetheless, Okada also cautions that some CLOs — say, a tranche trading at 50 cents on the dollar — may be way overpriced. “The critical variable to attractive returns is to have a deep understanding of the underlying portfolio and the CLO structure itself, as well as the behavior of the CLO manager,” Okada says.
A grasp of today’s unusual market context also helps. Interest in CLOs is confined for the time being to the secondary market; new issuance remains moribund (though some optimists predict a revival this year). But even the secondary market must still overcome a loss of investor confidence.
Most investors simply assumed that since bank loans to large companies were unrelated in any way to subprime mortgages, the CLO market would escape the catastrophe that befell mortgage-backed securities. How wrong they were.
The subprime contagion swept across all sorts of structured products, and supposedly uncorrelated assets converged as never before. CLOs felt much more than a glancing blow from the mortgage crisis, because the players — investors, counterparties, underwriters and reinsurers — were much the same across both markets.
Caught up in the systemwide deleveraging, CLO investors had to try to sell into a market in which buyers were scarce or nonexistent. Observes Yang, “The underlying loans began to experience unprecedented price volatility in the secondary market.”
Yet looking closely at the fundamentals of CLOs produces a much more positive impression than scrutinizing the dodgy mechanics of subprime mortgage-backed securities. Essentially cash-flow deals, CLOs depend mainly on a diversified pool of interest-paying bank loans secured by corporate assets, such as accounts receivable. Consequently, they provide far more transparency than do subprime-based securities; this comes in the guise of ready access to monthly and quarterly company financial statements as well as to management itself.
And although CLOs are akin to mortgage-backed securities in that they consist of different tranches, each with its own rating, with most CLO tranches the underlying assets — corporate loans — are themselves rated (and usually subject to payment-maintenance covenants). Hence, CLOs provide deeper underwriting and due diligence standards than do subprime mortgage-backeds. Another differentiator with CLOs is that they are actively managed from a credit perspective by a collateral manager.
It is, in fact, unusual for CLOs to default. A March research brief by Moody’s Investors Service reported that only six out of the more than 500 U.S. cash-flow CLOs rated by the agency since 2008 have experienced defaults, and three of these were “subsequently cured.” Furthermore, all six defaulting CLOs were “atypical.” Securitization appeared to work with CLOs.
Ling Yu, a consultant at Asset Backed Consulting, a New York–based securitization consulting firm, comfortingly adds, “The fundamental credit-performance projections for high-yield loans at CLO closings have been relatively dependable during the current credit crisis and in prior economic downturns in the past decade or so.”
Nevertheless, CLO pricing was shaken by the crash. In 2008 spreads widened dramatically, and even though they have tightened some in recent months, CLOs can plainly still be real bargains. Or as Okada puts it, “Friction in the CLO space creates opportunities.”
Of course, the decision to invest in CLOs depends on the answers to many questions: What is your outlook for the high-yield loan market? What are your alternatives? Which tranche should you invest in? Is it priced appropriately?
At the very least, though, for investors willing to ask those sorts of questions seriously, CLOs are worth a closer look. Still, caveat emptor is definitely the applicable principle here. Note carefully how consultant Ling Yu hedges her endorsement: “In this sector, there are many opportunities and potential investment winners for long-term investors with extensive high-yield and CLO experience.”
