Briefing – CLO: a post-pandemic resurgence | Characteristics

Exactly a decade after the collapse of Lehman Brothers, the secured loan bond (CLO) market is breaking records. In 2018, nearly 130 billion dollars (113.6 billion euros) of CLO paper were issued in the United States and 45 billion euros in Europe, a sign that the crisis of confidence caused by the Great Financial Crisis was finished.

The show slowed down slightly in 2019, then COVID-19 arrived, raising fears of a long and painful default cycle. However, thanks to government and central bank support, US and European corporate default rates have been lower than expected.

In fact, although it is a complex asset class, from a default perspective, CLOs compare favorably to investment-grade credit bonds and high-yield bonds, says Shakil Shah, head of the portfolio. credit and strategy for European structured products at Payden & Rygel.

This goes without saying, since the pooling and tranching of diversified underlying loans purchased by CLOs is a means of spreading and therefore minimizing credit risk.

Even at the height of the financial crisis, default rates for CLOs were relatively low, according to Shah. He says, “If you consider the structural protection they offer, CLOs are actually a very safe asset class. Even looking at the credit spectrum down to the double-B and single-B space, defaults were 1.9%, dating back to 1996. At the end of 2020, the 12-month cumulative default rate on loans underlying was around 4%. , compared to 11% during the financial crisis.

This year, thanks to a happy combination of low interest rates, abundant liquidity and a relentless search for yield on the part of institutional investors, companies have continued to issue loans in increasing volumes, most often with the support from private equity sponsors.

CLO managers seized the opportunity, issuing a record $ 126.8 billion US CLOs in the year ending late September, according to S&P Global. In Europe, emissions have so far reached 34 billion euros for the year, according to data from Payden & Rygel. The total amount of CLOs in circulation is well over € 1 billion and the global issuance is approaching new highs for 2021.

Industry veterans such as Norinchukin Bank of Japan, which was at one time the world’s largest owner of CLO wafers, and PIMCO, which last year issued its first CLO in ten years, are supporting the market. in this phase of growth. But the appetite for CLO issuance is so strong that institutional managers are launching new CLO platforms.

Managers benefit from diversification within the investor base. Shah says, “If you look back to 2017, 40% of the investor base in the triple A space was in banks. It is now much more diversified, with a roughly equal share between asset managers, banks and insurance companies, even in the lowest rated tranches. This is a positive trend that can only serve the CLOs in the future. “

Credit specialist Muzinich & Co recently launched a CLO platform, hiring Brian Yorke, who has two decades of industry experience, as the global head of CLO management. The New York-based firm specializes in high yield and loans, and Torben Ronberg, Head of Syndicated Loans, says: “The launch of the CLO platform is a natural extension of what we are already doing. It makes a lot of sense at this point in the business cycle. “

Yorke says Muzinich intends to become a “consistent and regular” issuer of CLO, starting with two US-based transactions next year, then moving to Europe and eventually Asia through the following.

“In my entire career, and certainly over the past decade, I haven’t seen demand for CLO stocks as robust as it is today. It’s because of the convergence of low rates and really strong economic growth, as well as the fact that private equity firms are sitting on record highs of dry powder, ”says Yorke.

“The rising rate environment is also stimulating demand for CLO debt, due to their variable rate nature. With low defaults and strong credit performance, CLO debt tranches compare extremely favorably to their corresponding companies on a relative value basis and across the debt stack, ”adds Yorke.

The European market, in particular, has grown so rapidly that the infrastructure supporting it is feeling the pressure, according to Deborah Cohen Malka, deputy portfolio manager at AlbaCore Capital.

AlbaCore, a credit-focused investment firm founded by a team of former employees of the Canada Pension Plan Investment Board (CPPIB), is opportunistically investing across the market and has launched three CLO since its creation in 2010.

Cohen Malka points out that the leveraged loan market has grown so much over the past year that banks and agencies are not fully equipped to handle the flow of settlements, which means settlements take longer. longer than what managers and CLO buyers might expect.

“It affects distribution across the CLO structure. In our case, we have relied on our trading strategy and we ensure that the investor base supports us, allowing a larger bond allocation within the CLO. This allows us to manage longer payment terms, ”explains Cohen Malka.

However, there is no indication that such rapid growth dilutes the attractive features of the asset class. CLOs will continue to remain attractive relative to other credit securities, according to Paolo Malaguti, CEO of Credit Vision, a provider of credit-focused portfolio analysis.

This is despite the tightening of prices for CLO tranches, especially the highest rated tranches, due to continued and robust demand.

The competition is heating up
Competition for assets among credit managers is also intensifying, with direct loan managers diverting borrowers from largely syndicated loan syndicates. As a result, the differences in portfolio allocation strategies between CLO managers are becoming more apparent, Malaguti explains.

“Due to the growing number of opportunities available, issuers and buyers of CLOs are stepping up their efforts to analyze the underlying portfolios in a granular fashion to accurately determine their risk / return profile.

European CLOs dominate the securitization market

“For example, the managers of CLO are keen to show that the leverage of their underlying loans is lower than that of their peers, but with similar returns. We see a lot of investment in portfolio analysis, ”says Malaguti.

Transparency on the underlying loans may prove more difficult to achieve than in the past due to the more flexible loan terms that lenders accept.

“The sustaining covenants that were once used to regularly monitor leverage on the underlying loans are no longer there, as borrowers are no longer required to provide this information. When present, sustaining covenants are often set at flexible levels that make them almost insignificant for the purposes of assessing the credit quality of the underlying borrower, ”explains Malaguti.

“Having said that, CLO managers tend to be very thorough in how they select the underlying loans in terms of credit risk. It is difficult to predict waves of defaults triggered by excessive leverage, ”he adds.

The differences in risk-return profiles between CLO’s portfolios will be reflected in the pricing of the underlying loans in the secondary market, according to Malaguti.

Transparency is important, but mastering the investment process of a CLO manager is crucial, says Shah of Payden & Rygel.

He says: “We have visibility into the underlying loans. However, from our perspective, we are not necessarily looking to guess what the manager of CLO does and how he manages his portfolio. We work with our credit team to understand the lending and sector risks in the collateral pool, but rather it is about familiarizing ourselves with their investment process, understanding and knowing very intimately the managers and analysts involved. .

Headaches related to inflation
AlbaCore’s Cohen Malka thinks CLO buyers are more concerned about inflation. She says: “We have focused on how inflation can affect the companies in our portfolio, looking at their earnings, ensuring they are protected by a pass-through mechanism or cost savings initiatives. .

“We have a conservative lending strategy and an active trading strategy, which means we can rotate our portfolios if we see pressure on margins or leverage.”

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