Collaterlised loan obligations are the sort of structures that got mauled in the 2008 financial crisis but they have a place in a portfolio, the author of this article argues.

Several years on from the worst financial crisis since, arguably, the 1930s, investors are wary of those structures that were said to be at the heart of the trouble. For example, pools of loans and bonds that were packaged up and sold to investors, thereby severing the old link direct link between borrower and lender, have been accused of driving reckless behaviour. But is that fair? Some of the tools of modern finance, such as collateralised debt obligations and their cousins, haven’t been discredited so much as been rethought. In this article by Alexandre Martin-Min, co-head of securitised and structured assets at AXA IM, he considers the market for collaterlised loan obligations. The views are not necessarily those of this publication’s editors but are an important part of the investment debate. We invite readers to respond.

With investors hunting for investments that offer higher yields and floating rate cash flows, it is apparent that the tide is turning back towards structured finance assets. Collateralised loan obligations may have fallen out of favour following the 2008 financial crisis, but they maintained their robustness, few long-term investors experienced losses, and these instruments are now trading at a premium despite narrow credit spreads and rising rate expectations. The investment opportunity in CLOs should not be overlooked.

The role of securitisation
Securitisation is the packaging of secured assets into tradable securities, which offers long term investors an investment opportunity outside of government bonds, bank debt and corporate bonds.

The structured finance market was initially developed in the US during the 1970s to support the growth of residential mortgage loans. Today, structured finance offers investors access to a range of underlying assets, including mortgages, credit cards, corporate loans and real estate.

Without structured finance, these underlying exposures are held directly by banks. The structured finance sector creates a mutually beneficial relationship, enabling investors to access new sources of return while allowing banks to transfer some of their balance sheet risk.

The US structured finance market currently stands at $10.1 trillion, making it the second largest debt market in the world after US government bonds. The European market is markedly different at €1.9 trillion (about $2.2 trillion), but it is expected to develop in coming years as European regulators look to limit or reduce the size of bank balance sheets.1

The mechanics of a CLO
A CLO is a portfolio of senior secured loans diversified across issuers, industries and geographies. The portfolio is divided into different “tranches”, each of which have different credit ratings and expected cash flow profiles. Higher-rated senior tranches offer lower coupon rates but have first priority on the cash flows and collateral in the event of default. At the other end of the spectrum, the equity tranche is not rated at all and may not be secured by collateral, but receive the excess cash flows from the structure. CLO investors choose a tranche based on their risk tolerance and return objectives.  

One of the implicit “rules” that should govern structured finance activity is that tranches should be structured on underlying assets that have a long and stable track record.  Notably, this was not the case with subprime mortgages, which were a relatively new asset class. Neither banks nor investors sufficiently understood how these assets would behave throughout a full economic cycle.

Due to the stresses applied by rating agencies when contributing to the issuance of CLO deals, CLO tranches have a far better track record than equivalent-rated corporate bonds both in terms of rating migration and in terms of default.
 
December 2007 CLO ratings, as at June 2014, had been either stable or migrated. During the period, 66 per cent of AAA-rated CLOs maintained their rating, while c. 1 per cent of them were downgraded to AA. Around 33 per cent of ratings were removed, the vast majority of which were reimbursed at par without any default.

The 2008 credit crisis impacted short-term CLO investors differently to longer term investors. Short term CLO investors, mainly hedge funds, became forced sellers as prices plummeted. For longer term CLO investors that maintained their positions, over time, the tranches performed as expected.  During the crisis, cash flows due to holders of the Equity tranche were not distributed to protect the structure and instead were maintained within the CLO, increasing the size of the underlying loan portfolio. CLO managers were then able to reinvest the accumulated cash when loan prices were low and thus were able to recoup most of the losses through reinvestment at discount.

Demands for a premium
Given the attractive credit characteristics and consistent and resilient history of the CLO, demand in this market is growing again. However, CLO debt tranches currently trade with a significant premium compared to other credit instruments. This is due to the influence of factors such as regulation, e.g. Solvency II in Europe, which imposes penalties on banks and insurance companies that hold CLO tranches, who now demand a higher spread to compensate for the additional costs.

In addition, there is atomization of the market below AAA, requiring investors to source and assess numerous different deals in order to fulfil their target allocation. They want to be compensated for this additional effort through higher premiums.

Lastly, memories remain of the 2009 price-pattern, when forced-selling caused prices of CLO tranches to plunge. Today, however, leverage of CLO tranches is very rare as real money players are now the biggest participants in this market – as opposed to hedge funds.

What are the risks?
Importantly, investors should not charge blindly into the asset class but instead be selective with issuers and look for asset managers with experience and access to markets.

Back in the game?
The CLO opportunity should not be overlooked. Supply will continue to grow as the US market uses structured finance to support economic growth and to minimize the size of bank balance sheets, and the European market expected to follow suit. Secondary trading levels exceeded $100 billion in 2013, so improvement in liquidity will act to encourage investors. CLOs continue to be robust and resilient and through careful due diligence and selection, CLOs can play a role in a portfolio.