Practical analysis for investment professionals
27 March 2013

Fifth Anniversary of the Credit Crisis: Should you Buy CLOs?

Posted In: Drivers of Value

As the fifth anniversary of the financial crisis approaches, financial products that start with a “C” and end with an “O” still trigger fear and trepidation in investors. This alphabet soup of products ― including collateralized debt obligations (CDOs), collateralized mortgage obligations (CMOs), and collateralized loan obligations (CLOs) ― still carries a negative connotation to many people. But this mentality has gradually begun to change because of the dramatic effect of the U.S. Federal Reserve’s quantitative easing (QE) program. The Fed has been on an asset-buying spree, removing government bonds from circulation and forcing investors to move into riskier credit products for yield.

The Fed now owns more than $2.8 trillion in securities and has left the market with too many dollars chasing too few assets. J.P. Morgan estimates that the current rate of QE will create a shortfall, including coupon reinvestment, of up to $900 billion in spread products. Displaced buyers of U.S. Treasury bonds and agency-backed mortgages initially moved into investment-grade corporate bonds, municipal bonds, and high-yield bonds, among other products. But now they are drifting further out on the risk and illiquidity spectrum.

Today’s discussion considers CLOs — what they are, how they have performed, who is buying them, and what kind of value they offer. I will also list a few options for individuals and smaller institutions who want to gain access to this asset class.

CLO overview and performance attributes

First, a brief refresher for readers who are unfamiliar with CLOs.

A CLO is a pool of leveraged loans packaged into one larger security that’s then sliced into different levels of risk for different investors. These loans are common in leveraged buyout financing, or LBOs, and include well-known entities such as Burger King and Toys “R” Us.

Unlike other areas of the securitized markets, the performance of leveraged loans and the quality of collateral backing the debt have proven to be much better than other securitized collateral that went bad, such as subprime mortgages. The trailing 12-month default rate for U.S. leveraged loans has averaged 2.5% during the past 20 years, with a high of 9.6% during 2009. Recoveries on defaults have averaged roughly 70% with a low of 50% during the crisis.

“The collateral is quite diversified in CLOs,” said Matt Natcharian, head of structured finance at Babson Capital. “These are actual loans to companies that are individually rated, have full loan indentures, observable prices, and industry diversification.”

CLO market landscape: where we came from and where we are today

The peak years of CLO issuance were 2006–2007, when a collective $185 billion in CLOs were issued. That amount fell to $1.1 billion and $2.9 billion in 2009 and 2010, respectively. Today, more than $250 billion worth of U.S. CLO debt is outstanding.

With the chase for yield at full speed, issuance has started to pick up. Last year, CLO issuance exceeded $50 billion. So far in 2013, more than $22 billion has been issued, an annual pace of $100 billion.

CLOs have become popular for a few reasons. First, as yield has evaporated in other spread products, investors have had to reach out along the credit spectrum to other asset classes, such as non-agency mortgage-backed securities, commercial mortgage-backed securities, leveraged loans, and CLOs. Second, and perhaps just as important, CLOs have floating interest rates. Exposure to floating rate products is becoming increasingly popular among fixed-income managers who fear the inevitable rise of interest rates from current historic lows.

Jefferies economist David Zervos described the market’s renewed infatuation with CLOs in a recent note: “This is the next logical step for fixed-income investors who are boxed into financial repression. Oddly enough, one year ago we were begging clients to look at our one new issue CLO in the market. Now, the deals are coming nonstop on reverse inquiry for more equity. I even spoke with a few accounts in the last week that discussed creative ways to lever the ‘cheap AAAs.’ The CLO market, as well as other structured markets, allow fixed-income investors to press toward the edges of their investable universe. By taking 100 loans, shaving off the riskiest [loans], and placing that in a security, we can create a supposedly fixed-income security that looks a lot like an equity. It fits in the box, sort of!”

Investor bases differ widely among CLO tranches

Babson Capital’s Natcharian described a different set of buyers at the top of the CLO structure today.

During the heyday of CLOs in 2006 and 2007, he said, large European and Asian banks would purchase hundreds of millions of dollars of AAA rated pieces at spreads as tight as 20 to 25 bps over three-month LIBOR rates. They would then buy protection on the position from a monoline insurer and be left with what they considered a “risk-free” position.

Although those AAA pieces never suffered losses, those buyers are no longer in the market. Today, big Wall Street banks sell AAA CLO tranches in smaller pieces to banks and insurance companies instead. Even though these securities have tightened more than 100 bps in the last year, spreads on AAA pieces remain historically wide at 100 to 115 bps over three-month LIBOR rates. These AAA spreads have tightened by about 25 bps this year, according to J.P. Morgan.

“The appeal of CLOs is getting a high-yield credit spread without taking the interest rate risk,” said Natcharian. His team manages more than $9.8 billion of CLOs for clients, including the insurer MassMutual, Babson-managed CDOs, and pension funds.

Further down the securitization structure of CLOs, the AA–, A–, and BBB rated pieces are most often owned by insurance companies, whereas BBB and BB rated tranches are the favorites of hedge funds, money managers, and pension funds. CLO equity investments are the most leveraged and risky investments, with targeted annual returns of around 15%. The excess spread that goes to CLO equity tranches is the remaining spread from the underlying bank loans after the CLO debt tranches are paid and fees and expenses are taken out.

Exposure for individual investors and smaller institutions

With the chase for yield showing no signs of slowing down, large investment firms have turned to CLOs as part of their recent incremental purchases. For instance, DoubleLine Capital has added CLOs to its DoubleLine Opportunistic Income Fund (NYSE: DBL) as well as their flagship DoubleLine Total Return Fund (DBLTX). Analysis of their holdings as of the end of February 2013 shows that DoubleLine continued to add CLOs during February.

Pure play exposure to lower-rated mezzanine and equity tranches can be found through Oxford Lane Capital Corporation (NASDAQ: OXLC) as well as Tetragon Financial Group (TGONF). Oxford Lane is very small and rather illiquid with a market cap of only $78 million. But it does have the appeal of an annual dividend yield of about 14% and shares trading at about 8% discount to net asset value (NAV). Potential investors should note that the management fees are far higher than traditional fixed-income closed-end funds.

Tetragon ($1.5 billion market cap) is a more interesting situation. It’s a closed-end investment company that invests primarily in pre-crisis CLOs (56% of portfolio). Despite growing NAV from $9.47 in Q4 of 2010 to $14.65 as of Q4 of 2012, the company continues to trade at a significant 25% discount to NAV. Noted hedge fund manager Leon Cooperman’s Omega Advisors has a 14% stake in the company and has been vocally bullish on the firm despite calls for improved corporate governance practices. With 10% of the company in cash and shares trading at a significant discount to NAV, the company has steadily bought back shares, a practice that is obviously accretive.

Outlook remains promising

Going forward, the outlook for CLOs appears to be quite promising. CLOs remain attractive for investors on a spread basis given the environment of negative net supply among spread products in general. Although credit markets have admittedly heated up, it’s expected that the default environment should remain benign for the next few years. Furthermore, with continued fears of rising interest rates, the floating rate nature of CLOs should give them extra appeal among investors.

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Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

About the Author(s)
David Schawel, CFA

David Schawel, CFA, is a portfolio manager for New River Investments in the Raleigh/Durham, North Carolina area. Previously, he managed a $2 billion fixed income portfolio for Square 1 Financial, which he joined in 2008.

3 thoughts on “Fifth Anniversary of the Credit Crisis: Should you Buy CLOs?”

  1. David Merkel says:

    Does it concern you at all that older cousin of CLOs, Closed-end Loan Participation funds, all trade at premiums to NAV?

    http://online.wsj.com/mdc/public/page/2_3040-CEF41.html

    It’s rare for all of them to be at a premium at once. Really rare, I don’t think I have ever seen it before.

  2. David Schawel says:

    It would be a factor I would consider if I was strictly looking at levered loan CEF’s. Given the chase for yield, I’m not suprised those are trading at premiums.

    The premise of this article was more targeted at institutional buying of CLO’s and also ways that individuals & smaller investors can get exposure. Interestingly, the pure plays on CLO’s (Oxford Lane & Tetragon) are trading at substantial discounts to NAV – one reason why I believe they are worthwhile to evaluate for long positions. So not quite the same valuation considerations despite all of their differences.

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