CLOs: why leveraged credit markets should outperform in the next downturn

August 2015 | SPOTLIGHT | BANKING & FINANCE

Financier Worldwide Magazine

Collateralised loan obligations (CLOs) represent a growing segment of the $1.3 trillion asset backed securities (ABS) market. Limited to syndicated corporate loans, CLOs are distinguishable from another class of ABS, collateralised debt obligations (CDOs), which include loans ranging from cars and corporate lending to student loans and residential mortgages. CLOs are actively managed by credit professionals and the acquisition of loans into special purpose vehicles funded through tranches of structured securities placed with investors seeking varying degrees of risk and return. The structure of CLOs originated in mortgage backed securitisations and were first introduced in the late 1980s.

Confusion with other asset backs with a history of poor returns and resurgence in issuance colour perceptions and focus concerns on CLOs. Performance of a predecessor product known as Collateralised Bond Obligations (CBOs) was impaired by junk bond holdings following the high yield meltdown in 1990. This taint may be reinforced by losses incurred by multi-asset class CDOs funded in 2005-07 leading up to the subprime collapse. The subjects of extensive investigations by regulators, CDO losses following the crash were estimated to have exceeded $500bn. While these losses were attributable to a surge in CDO purchases of toxic residential mortgage securities, this stigma appears to extend to CLOs. Reflecting their weak performance, CDO issuance is estimated to be about $140bn in 2015, well below levels prevailing prior to 2008. In contrast, CLO issuances concentrating solely on leveraged corporate loans are flourishing. With year to date CLO issuance of $56bn, 2015 appears to be on track to nearly match a record achieved in 2014, exceeding $130bn.

‘Synthetic banking’

The growth in CLO issuance, coupled with the problematic performance of CBOs and CDOs, has led several business journals to postulate that the next credit market downturn will be magnified – if not triggered – by CLOs. Fortune titled an April 2014 commentary, ‘Collateralised loan obligations: our next financial nightmare’, suggesting that CLOs threaten a collapse of credit markets rivalling subprime. Inadvertently, CLO sponsors may have added to this hyperbole. As characterised by one major participant, Wells Fargo Securities, CLOs represent a “synthetic bank with a defined life and stricter covenants”. Whether synthetic or ‘shadow banking’, such labels imply lax underwriting and a systemic risk associated with pooling loans by unregulated financial intermediaries.

Reflecting such concerns, the Dodd-Frank Wall Street Reform and Consumer Protection Act, known as the ‘Volcker Rule’, includes specific regulations pertaining to CLOs. These range from a prohibition on commercial banks holding equity and trading CLO securities, a mandatory retention of 5 percent equity in each pool by the CLO manager, as well as directives regarding the security interest, amortisation and coverage ratios for conforming leveraged loans comprising a CLO. These regulations, to be phased in over the next two years, are a further acknowledgement of the growing importance of CLOs.

Out of the shadows

Measured by market share relative to the overall institutional loan market (historically a more important source of corporate credit than high yield), CLOs pre-crash were just below 20 percent. This level was exceeded in 2014 as the growth in CLO issuance in the US significantly outperformed both CDOs and leveraged loans.

The recovery in CLO market share, rather than a cause for concern, portends greater stability in markets and improved corporate funding options. This, in turn, may actually extend the current cycle and mitigate the impact of an eventual downturn. These salutary effects are based on three structural elements of CLOs. First, in contrast to bond mutual funds and exchange traded funds, other major sources of credit, CLOs eliminate the risk of ‘runs on the bank’. Buyers of debt tranche have a priority interest in the principal and interest earned from the underlying portfolio of leveraged loans. However, these investors have no right to call their loans. Historically, such withdrawals of bank deposits or redemptions from bond funds have been a major factor behind market reversals.

Second, the credit quality of CLO portfolios is proven. CLOs exclude the mortgage backed loans that caused such extraordinary losses for CDOs. CLOs afford diversity in credit risk in contrast to residential mortgage securities whose value proved tied to geography. Further, the pending implementation of the Volcker Rules requiring sponsor equity and capping leverage on pooled loans buttress confidence and should improve expected recoveries in the event of default.

Third, the sources of funding CLOs should be more stable in a rising rate environment than sources of traditional business credit. Based on studies of mature segments of ABS markets, Federal Reserve research supports the thesis that asset backed securities markets are less sensitive to interest rate changes and afford greater liquidity and price stability over cycles.

Brightening market and nonbank outlook

While still a relatively small percent of the corporate loan market, CLOs are likely to grow their share of the market following an established trend of disintermediation of corporate lending from depository commercial banks to shadow banks, including business development companies (BDCs), finance companies, and a plethora of other nonbank banks. As an important capital source underpinning this disintermediation, the CLO product’s inherent flexibility to respond to changing markets has a two-pronged impact on credit markets. CLOs facilitate the availability of credit and improve market efficiency. Rather than a ‘financial nightmare’, these credit derivatives promise stability in funding, and greater efficiency in capital flows and securities pricing. Providing a buffer from rising interest rates, CLOs should support markets as volatility increases and markets inevitably correct. As nonbank financial intermediaries expand, the impact of CLOs will be magnified as both credit markets and returns for those intermediaries benefit from a multiplier effect. The interrelated factors of expanding credit and improved efficiency benefit the leveraged loan market particularly in an eventual downturn.

Anders J. Maxwell is a partner at Peter J. Solomon Company. He can be contacted on +1 (212) 505 1683 or by email: amaxwell@pjsolomon.com.

Anders J. Maxwell

Peter J. Solomon Company