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CLOs are structured credit securities which give investors different levels of risk exposure to the bank loan market. This paper looks at the degree of sensitivity of “mezzanine” tranches of CLOs (i.e. those tranches rated BB and below) to the underlying bank loan market. The paper also looks at the current attractive levels of spreads in the CLO market.
CLOs are structured credit securities which give investors different levels of risk exposure to the bank loan market. This paper looks at the degree of sensitivity of “mezzanine” tranches of CLOs (i.e. those tranches rated BB and below) to the underlying bank loan market. The paper also looks at the current attractive levels of spreads in the CLO market.In this article
In JANA’s recent Fixed Interest Research Trip, we explored the potential returns for taking on increased exposure to credit via Collateralised Loan Obligation (CLO) debt tranches, given recent market movements in CLO markets. Investors though need to appreciate that CLO’s can be volatile, as they tend to have an inherent leveraged exposure to the underlying leveraged loan market. In JANA’s view, investors are compensated for this volatility and credit exposure. Investors are also compensated for the additional complexity and illiquidity the asset class exhibits, which we delve further into below.What is a Leveraged Loan and a CLO?Leveraged loans are “leveraged” because they comprise funds lent to companies with already high amounts of debt (approximately 5x Debt/EBITDA). Therefore, the ‘equity’ held in these companies is quite leveraged.A Collateralised Loan Obligation (CLO) is – to put it simply – an exposure to a pool of loans, with the purchase of those loans backed by the issuance of debt collateral. The different parts of a CLO structure then are themselves “leveraged” exposures due to both the credit exposure to these leveraged loans, and the leverage of the CLO structure itself. This “structural leverage” of a CLO is because the equity holder in a CLO only puts in a small amount of equity (say 10%) and borrows 90% of the purchase price of the pool of loans bought. This borrowing to buy the pool of assets is done via the sale of CLO tranches. In this example then, we would say that the equity in this CLO is “ten times levered”.As a result of such elevated levels of leveraged exposure, if the loan market experiences severe credit defaults, the entire equity has the potential to be wiped out. JANA recently conducted an analysis of the movement in the prices for the different debt tranches, as against the movement in the prices of the underlying bank loans. The below chart looks at one of these relationships, by analysing the last seven years of CLO BB tranche spreads and how sensitive they were to the movements of the underlying BB rated leveraged loans. Whilst it is evident that CLO spreads are highly volatile and their sensitivity to the movement in the underlying loan market fluctuates materially, if we look to the annual averages the sensitivity is smoothed out. Looking at the entire period, the average is 7.5 times. This implies that on average CLO spreads move 7.5 times as much as the underlying loan spreads (i.e. if the loan spreads increased by 10bp, on average CLO spreads increase by 75bp). This is less than the “10 times” leverage of CLO equity, which we would expect as the equity holder has the riskiest piece as it is the most exposed to the underlying assets (the loans), and the BB CLO tranches are thus somewhat protected by the equity underneath.This level of 7.5 times probably does overstate by some margin the true underlying credit risk exposure of the CLO BB tranche due to the short history and the volatile nature of credit markets over the post GFC period. But nevertheless, this historical figure of “7.5 levered” is at least a useful indication on what the leveraged exposure of a lower-rated debt tranche in a CLO can be to the underlying loan market.JANA tends to think of CLO BB tranches as probably somewhere between 4-7x leveraged to the underlying loan market. However, the above chart illustrates that this apparent exposure to the underlying loans will fluctuate as the market’s sensitivity to default risk, quality, illiquidity, and complexity changes – more on this below.The OpportunityWe believe that CLOs are an attractive investment in a diversified portfolio - but as mentioned, investors need to be cognisant of the potential volatility that can be experienced: a leveraged exposure to leveraged loans can perform badly in a risk-off environment.However, recently some parts of the CLO market seem to be acting as if the overall market is already in (or at least approaching) such a risk-off environment! To JANA there seems to be a disconnect between subsectors like CLOs and asset classes such as equities. Certainly, with equities reaching all-time highs and having risen 23% Year-to-Date at time of writing, it is hard to believe that markets are in a ‘risk-off’ mode, as indicated by the recent performance of parts of the CLO market. The above chart shows the spread between BB rated Leveraged Loans versus BB rated CLO tranches. This spread in these securities, with the same credit rating, has risen 260bps since the start of 2018, to hit a peak of 518bp in October 2019. That is a big move and appears to be indicating a period of stress almost on par with the stress of 2015/2016.We do question whether things are really that bad. At the start of 2016, the US Federal Reserve had started increasing rates, and oil was at $38 a barrel with many energy companies underwater. Now the Fed is cutting rates and the Fed balance sheet expansion program looks set to recommence. Oil is $63 a barrel. Whilst US growth is slowing, it is not at zero percent. US Corporate defaults are very low and are expected to rise only to about 2.2%, which is not an environment that would frighten credit markets.Whilst the market has retraced the spread between CLOs and the underlying Leveraged Loans a little since we first alerted clients to this opportunity in October, the spread remains elevated and attractive, in our opinion.
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