As scrutiny of the $1.2tn leveraged loan market has increased, focus has turned to the market’s main source of support: so-called “collateralised loan obligations”.
CLOs are vehicles which take a group of risky loans and then use them to back a series of bonds of varying degrees of safety. Investors in the most perilous, lowest-rated “tranches”, as they are known, are rewarded with higher returns but are hit first if the underlying loans — issued to low-rated or heavily indebted companies across the US — begin to default.
As such, CLOs resemble other structures that rocked the financial system a decade ago, such as “CDOs”, which issued debt backed by bundles of (what turned out to be) junk mortgage bonds. But both investors and CLO managers say this time is different.
“[CLOs] begin with a ‘C’ and end with an ‘O’,” says one investor, adding that parallels should end there. “Overall, the asset class has proved resilient across several market cycles.”
The record is certainly encouraging. Of the 4,322 CLO tranches that were rated by S&P Global Ratings before 2008, only 38 tranches across 22 CLOs have defaulted, notes LCD, a division of S&P Global Market Intelligence. And there has never been a default of a triple A-rated tranche.
But the market has grown a lot since then. The value of outstanding CLOs has doubled since 2007 to more than $600bn at the end of 2018, consistently representing around 50 per cent of the investor base for leveraged loans, according to data from Citi.
Some protections have increased, too. On average, a CLO would have to experience losses in excess of 35 per cent before triple A investors would lose money, according to Fitch Ratings. That is up from an average of around 25 per cent before the financial crisis – the result of rating agencies changing their recovery assumptions for the underlying loans, while setting a higher bar for CLO managers to reach that triple A rating.
“We wanted to make sure that the triple-A rated notes are protected,” says Kevin Kendra, head of US structured credit at Fitch.
Those structural changes mean that CLOs concentrate the risk of losses in the hands of a small group of hedge funds and other investors with a high tolerance for big swings in performance. In the fourth quarter last year, for example, leveraged loan prices tumbled but most CLO tranches still ended the year with positive returns for debt investors. Triple A tranches returned an average of 2.7 per cent for 2018, according to Citi.
The investors who lost out were investors in the riskiest “equity” tranches, who ended the year with losses of 11.4 per cent.
“When the market falls and you have to mark down your portfolio 10 per cent that hurts but it doesn’t create forced sellers,” says Chris Acito, chief executive of Gapstow Capital Partners, which invests in CLO equity. “This market is not held by weak hands.”
But that does not mean the product carries no dangers.
Already, strong demand from CLOs has helped to shred many of the investor protections that were once routinely embedded in loan documents. Financial maintenance covenants — contractual agreements that would limit the amount of leverage a company could take on, or mandate thresholds for the amount of cash they needed on hand to pay interest on their loans — have been eroded.
That means that when a downturn comes and borrowers start to hit trouble, losses for loan holders could be greater than they had imagined. That filters through to CLOs, as managers have less cash to pass through to investors. “I do think credit quality has deteriorated,” says Jeanne Manischewitz, a partner at hedge fund York Capital Management. “Part of that was fuelled by CLO formation.”
Another unsettling development for investors: CLO managers have given themselves more flexibility over what they can invest in, such as the ability to fill their vehicles with more second-lien loans, which sit lower down in the capital structure of a company than more senior, first-lien loans.
“We do see some weaker CLO docs in 2018,” says Maggie Wang, a CLO analyst at Citi. “It mirrors the weaker documents in the leveraged loan market.”
Regulatory standards have weakened, too. At the end of 2016, CLO managers became bound by a requirement that they must hold 5 per cent of the economic interest in each new deal they sell, in a bid to align their interests with those of investors.
But after less than two years, the Loan Syndications and Trading Association, the main industry group, managed to get the rule repealed.
Still, there is little danger of a big blow-up, says Stephen Ketchum, founder of hedge fund and CLO manager Sound Point Capital. “I think the presence of CLOs in the loan market is overwhelmingly a good thing,” he says.
