By Davide Martellozzo, Simone Bertani and Leonardo Astegiano
Collateralized Loan Obligations (henceforth, CLOs) have become increasingly popular in the post-crisis era because of some intrinsic features such as strong credit performance and appealing risk-return profile, making them an attractive asset class to the eye of the investor. Indeed, according to Bloomberg Intelligence, Collateralized Loan Obligations have outperformed hedge funds over the past five years in terms of cumulative return.
On the other hand, CLOs are nowadays employed by credit institutions as an efficient tool for liquidity management: indeed, the issuance of such structured securities allows to transform illiquid loans into available funds. Finally, as a result of the generalized low yields of government bonds across the globe, the fixed income desks of many asset managers have progressively tilted their portfolio allocations toward the CLOs market. As an example, Guggenheim Capital LLC actively manages a $45 billion structured credit portfolio where CLOs approximately account for one-third of the total value.
What exactly is a Collateralized Loan Obligation?
“A Collateralized Loan Obligation is a securitization transaction containing corporate loans such as syndicated and/or leveraged loans made to corporate borrowers and private equity funds.”
From this definition we immediately understand that a CLO is a peculiar form of structured credit that can be considered as an asset-backed security whose underlying is made by a diverse pool of bank loans.
To better understand how a CLO is originated, let’s consider a commercial bank issuing long-term loans (preferably secured) to both corporate clients and private equity funds that will employ the cash to expand their activity through, for example, an acquisition of plant and equipment or financing an LBO. However the loan is employed, both corporate clients and private equity funds have the obligation to reimburse both the owed capital and interest to the credit institution at the agreed upon dates. Note that, from the bank’s standpoint, this operation consists of an immediate outflow that will be compensated by a stream of future intermediate inflows and a final repayment of the capital at maturity. This operation configures as an illiquid asset in the bank’s balance sheet because of the long-term nature of loans. Since the commercial bank is specialized in collecting deposits and granting credit in various forms, it typically owns portfolios of corporate loans (diversified across industries and geographies to mitigate credit risk) characterized by relatively high yields but illiquid nature. Hence, it would be extremely convenient to “sell” these loans portfolios, under the constraint of preserving those high yields, with the ultimate goal of obtaining liquidity to reinvest. This is possible through the securitization process that originates the Collateralized Loan Obligations.
Here is how it works. The loan portfolio is sold to a subsidiary company (namely, Special Purpose Vehicle or CLOs fund) that has been solely created to handle the securitization process and is usually based in a jurisdiction that have no corporation tax. Within the SPV, the CLO manager (also known as Collateral manager), which may be a small standalone firm or a large financial institution, is responsible for the origination of the CLOs and for the active management of the underlying loans throughout the life of the product. An investment bank then acts as an arranger structuring the deal and selling the CLO notes in the marketplace. As a result, CLOs are traded-securities with a defined price that is driven up by cash flow and liquidity and driven down by the credit risk of the underlying loans.
The number of senior secured loans that compose the underlying collateral pool typically ranges from 100 to 225. A single CLO is divided into different tranches (or classes) according to the priority of claim on the cash flows produced by the underlying pool of loans. Each class has a different risk-return profile: the higher reimbursement priority the yield, and vice versa. For instance, the lower priority of claim of tranche B with respect to tranche A is compensated with a relatively higher return. Every investor will therefore select a specific tranche according to their risk aversion. The figurative equity investor is the originator of the CLO whose eventual profits are the residual cash flows produced by the underlying pool of loans once every debt investor has been satisfied.
This cash flows distribution mechanism is known as “Distribution Waterfall”, a mechanism also widely used (with some variants) in the private equity industry to allocate fees between general and limited partners.
A key characteristic that differentiates Collateralized Loan Obligations from other forms of structured credit is their active management throughout the life cycle. The CLO manager is indeed authorized to buy or sell single loans that compose the underlying collateral pool in order to obtain trading profits or limit losses from deteriorating credit. Consider a CLO whose underlying collateral pool is composed by a portfolio of corporate loans: even if its theoretical exposure to idiosyncratic risk is negligible, a sudden deterioration in the creditworthiness of one borrower may provoke a decrease in the expected cash flows to reimburse the CLO investors. In this situation the CLO manager can change the underlying loan portfolio composition, selling the deteriorating credit and replacing it with safer ones. The active management of CLOs’ underlying collateral pool introduces upside potential but also an additional source of risk for the CLO investor because it may raise moral hazard concerns. Indeed, the CLO manager’s incentive to enhance return assuming larger risks may not be compatible with the investor’s preferences toward a safer allocation. For this reason, the active management of CLOs has been heavily regulated both in Europe within the CRR context, and in the US by the Dodd-Frank Financial Reform.
The CLO market
CLOs are not new. They’ve been an available investment instrument since the 90s and were around during the financial crisis of 2007-08 along with the riskier CDOs. At that time, however, they didn’t attract as much attention since they weathered the crisis with no significant damages. The heavy losses experienced by CDOs during the financial crisis were in excess of 90% in the junior tranches, while US CLOs experienced losses of just 0.9% in the BB tranches.
The main reason behind this remarkable combination of low risk and high returns is that, unlike CDOs which were backed by highly correlated mortgage loans, CLOs underlying assets are diversified across industries and jurisdictions, with low interdependence between single idiosyncratic risks. The collateral is also of higher quality, being composed of loans to companies often backed by private equity firms that have an interest in making sure that their investments and the loans financing them are successful.
Moreover, CLOs floating rate features have contributed to propel them into the spotlight of investors. Indeed, leveraged loans backing CLOs are mainly designed as floating rate debt, therefore ensuring protection to investors as rates rise.
Besides the intrinsic features, the surge of CLOs was caused also by external factors.
Definitely, the first outside driver is the exceptionally high debt level of the world economy, which has ballooned from $173 trillion at the time of the 2008 financial crisis, to 250$ trillion a decade after Lehman’s collapse. While financial corporations have become healthier thanks to post-crisis regulations, other companies, which used to have less debt than financial institutions, have been taking on increasingly high amount of debt to boost profit. As businesses have increased their demand for borrowing, investors have started to buy up risky corporate debt as profitable investments.
In particular, leveraged lending growth has been fuelled by the near-zero interest rates put in place by central banks in the after-crisis period, which had the effect of lowering the cost of borrowing to make it more attractive to corporates looking for mergers and acquisitions or debt refinancing. Low rates have also strengthened the so-called “CLO arbitrage”, made possible by the spread existing between the CLOs manager cost of financing and the yield returned by the investment in the pool of loans.
Another factor that led to the CLO market surge has been a regulatory softening relating the Risk Retention Rule, a regulation adopted by the SEC to implement the Dodd-Franck Act, designed to prevent a new subprime mortgage bond crisis. On February 2018 the U.S. Court of Appeals for the District of Columbia exempted CLO managers from hanging onto some of the securities they were selling to investors where the collateral for the CLO was acquired on the open market. Therefore, while CLO originators (banks, PEs, etc.) are still subject to the risk retention rule to keep “skin in the game”, CLO managers that acquire leveraged bonds on the secondary market are no longer exposed to capital constraints and can use more leverage in their activity. As a result, the fevered pace of CLO issuance has reached a peak in 2018 with more than $130 billion sold and returns outperforming the ones of the other market segments, both in fixed income and in equities, for most of the year.
Despite last year incredible performance, during the last months of 2018 and the first months of the new year the, CLO machine has slowed down. Indeed, CLO managers have been facing the toughest conditions since early 2016 as they are struggling with two main challenges: more expensive liabilities (the cost of capital faced by CLOs has increased to 200 basis points from 134 last January) and thin loan supply, which forces managers to buy loans in the increasingly expensive secondary market.
A second relevant aspect is that, although leveraged loans backing CLOs carry floating interest rates making loan prices immune from rates changes, CLO trends have shown signs of dependence on interest rates movements. Indeed, in a rising interest rate environment, as the one we are currently experiencing, investors, worried for a credit cycle turn, become more selective as they expect an increase in default levels, ultimately leading to a repricing in the credit market. Practically, this is what caused the $1.32 billion loss to loan mutual funds in November last year, when investors, following the widespread sell-off, asked for record redemptions that triggered a fall in the loan market.
Source: S&P Global
Several banks and analysts predict a slightly weaker supply for 2019, ranging from $90 to $110 billion. This will depend upon new debt issuances whose levels are yet not clear due to market uncertainties.
Finally, in a high demand-low supply market, there is the threat of a huge deterioration in the credit standards for new leveraged loans. Some people are worried that the faster the leveraged loan market grows, the more credit standards will drop, especially if, as is happening right now, leveraged loans offered by large banks decline and the share of those loans offered by non-banks (PEs, insurance companies, hedge funds, etc.) increases. This should represent a wake-up call since excessive risk-taking and worsening credit standard may, at a time when an economic downturn may occur, affect financial stability and real economy with an impact whose magnitude is difficult to assess ex-ante.
PE firms and CLOs
Private Equity firms have represented for the past 6 years a big source of demand for the leveraged loans that CLOs buy, and, at the same time, they are now among the biggest managers of CLOs in the world.
On one hand, the PE industry has taken advantage of a plentiful supply of cheap credit that characterized the after-crisis period to finance buyouts with high leverage. As the Trump administration relaxed regulation on corporate debt levels, the proportion of deals done with leverage of seven times or higher reached the 2007 record of 50% in 2018. At the same time, the use of covenant-lite loans, which enable borrowers to have most of the lender protections ripped out, is widespread, all occurring in the context of worse credit standards. The huge issuance of leveraged loans backing LBOs is closely interlinked with the astonishing growth of the CLO market (CLOs buy around 65% of all US leveraged loans).
On the other hand, Private Equity firms entered the business of CLO management in order to create a liquid market for their leveraged loans and consequently lower borrowing costs for their deals and make dividend recapitalization cheaper. The CLO management business, which is now dominated by PE firms, has also enabled this industry to increase assets under management and to diversify away from dependence on LBOs. Apart from the debt arm of the Blackstone Group, GSO Capital Partners, which obtained the crown of biggest CLO manager in the world in 2018 surpassing its historical rival, the Carlyle group, all the other big players of the industry occupy a spot in the top 100 ranking of CLO managers.
Just last November KKR Real Estate launched a massive $1bn CLO to finance 24 bridge loans it has originated and before that, in December 2017, Blackstone Mortgage Trust announced the closing of an equivalent CLO to finance 31 of its portfolio loans
The intensive LBO activity that is now underway is expected to continue to drive issuance of leveraged loans for the formation of new CLOs in the next few years. In fact, 2018 proved to be a record year for the LBO business with a series of double-digit billion dollar deals supported by more than $1 trillion of cash on which the PE industry rests. This immense amount of dry powder raised by PE firms coupled with the readily available and cheap debt have propelled leveraged loans backing LBOs.
Source: Wall Street Journal
However, as mentioned in the previous paragraph, the loan volume could be affected by rising costs for floating rate borrowers and a more uncertain corporate earnings outlook determined by the multitude of risks faced by the global economy. Just recently, after the Fed’s recent flip on interest rate hikes, US investors of CLOs moved to fixed rate assets and, in spite of a strong demand from Japanese banks, this phenomenon forced managers to offer juicier yields for the AAA slices of their deals: all the major PE firms offered spreads above 130bp on the new deals of 2019, wider than their last deals of 2018 which had spreads closer to 110bp.
Editor: Stefan Larsen
Authors: Davide Martellozzo, Simone Bertani, Leonardo Astegiano
Asset Securitization Report: https://asreport.americanbanker.com/news/gso-blackstone-to-issue-1st-clo-of-2019-with-aaa-at-libor-131
Public materials from Deloitte, PIMCO and Guggenheim Capital