Last week we explained how junk bond managers were buying increasing amounts of equities to “juice” their portfolios and propel their funds higher in the performance rankings.
While this struck us as a relatively recent development, the tried-and-trusted method of trading more risk for more yield is going gangbusters in the CLO (Collateralized Loan Obligations) market in 2017...
“The CLO boom is the latest sign of the ferocious hunt for yield permeating markets. Stellar performance over the past year has made CLOs increasingly hard to ignore for investors like insurance companies and pension funds. CLOs carve up a portfolio of bank loans to highly indebted companies into slices of securities with different levels of risk.
The securities at the bottom of the CLO stack offer the highest potential source of returns, but they are also the first to absorb losses if there are defaults in the underlying loan portfolio. The more senior slices offer lower returns but are more insulated from losses. CLOs are often lumped together with other alphabet-soup acronyms of the financial crisis, such as more toxic CDOs, or collateralized debt obligations. But CLOs actually weathered the financial crisis well: Investors who bought at the top of the market in 2007 suffered paper losses, but there were no defaults at all for the highest-rated securities.”
The “boom” terminology applied by the WSJ for 2017 is apt:
“...investors seeking yield are overcoming their skepticism and buying into securities that rely on financial engineering to juice returns. Volumes of CLOs, or collateralized loan obligations, hit a record $247 billion in the first nine months of the year, according to data from J.P. Morgan Chase Co. Fueled by a wave of refinancings and nearly $100 billion in new deals, that far outpaces their recent full-year high of $151 billion in 2014 and the pre-crisis peak of $136 billion in 2006.”
During 1994-2013, Standard and Poor’s estimated that losses on B-rated securities were only 1.1%. That doesn’t prevent some conservative investors from conflating the CLOs with the now-infamous CDOs, many of which were linked to subprime mortgages and spread and amplified losses in the U.S. housing market. One breed of CDOs are on a comeback path of their own, with more investors returning to them during an aging bull market.
Many people were “burnt by these acronyms from the crisis,” said Zak Summerscale, head of credit fund management for Europe and Asia Pacific at Intermediate Capital Group .
CLOs are essentially a subset of the CDO market. They are generally backed by senior secured loans on sub-investment grade companies – not sub-prime mortgages, as was the case with many of the worst-performing CDOs during the crisis. Despite the superior performance of CLOs, the general concept that CLOs are “bulletproof” while CDOs are “worthless” is incorrect. As former portfolio consultant, Eknath Belbase, noted https://www.quora.com/What-is-the-difference-between-a-collateralized-debt-obligation-CDO-and-a-collateralized-loan-obligation-CLO “What really matters is the collateral pool and the inter-asset correlation. You can create a very diversified (CDO) pool, NOT by collecting BBB rated tranches from the same type of badly underwritten mortgage bonds, but from securitized debt of, for example, corporate bonds and emerging market debt from a wide set of regions and industries. This could, in theory, be more diversified than a concentrated CLO that focuses on bank loans to just 2 US sectors, for example energy and mining companies. Overall, when compared within all fixed-income securities, CLOs and CDOs are much more similar than they are different (lions and tigers).”
Rick Rider, Blackrock’s CIO for global fixed income told the WSJ that “The demand for things like CLOs….is extraordinary,” - not surprising when the performance of BB-rated CLOs has matched the NASDAQ since JPM began recommending CLOs more than a year ago, the WSJ shows.
Market returns since JPM recommended buying CLOs last July
The recommendation was made by strategist, Rishad Ahluwalia, although the Journal reported that he is more cautious on the outlook. “CLOs have been an absolute home run,’ said Mr. Ahluwalia, though he added such chunky returns aren’t repeatable.”
Other commentators are divided in their views, although one comment did lead to raised eyebrows.
“Renaud Champion, head of credit strategies at Paris-based hedge fund La Française Investment Solutions, likes AAA-rated CLO tranches but with a twist: leverage. Mr. Champion says he buys senior European CLO tranches and borrows money against them to increase the size of his position between five and 10 times. That can amplify gains—and losses—significantly. ‘The difference between now and a year ago is the availability of leverage,’ he said. Bankers say only a small proportion of CLO buyers use leverage and emphasize that trades are subject to daily margin calls. That means investors have to post cash to cover mark-to-market losses on a position, which in turn limits how much they are willing to borrow. ‘The leverage in the system today is a fraction compared to pre-crisis,’ said J.P. Morgan’s Mr. Ahluwalia.”
Following the crisis, funds that manage a CLO are forced by regulators to retain 5% of a security issuance. That is undoubtedly a positive but, as ever, we struggle to think of an industry which is prone to more pro-cyclical risk-taking.