By James Williams – The CLO market enjoyed a resurgence of sorts in 2012 with approximately USD50billion in new issuance, overshadowing the paltry figure of around USD13billion in 2011. Much of this CLO activity remains in the US, where major players such as Dallas-based Highland Capital Management LP – the largest US CLO manager by AUM (approximately USD14billion) – and New York-based BlueMountain Capital Management continue to originate deals.
Currently, Highland manages 21 CLOs. Over the course of 2012, BlueMountain successfully issued two CLOs representing USD1billion of issuance according to Bryce Markus (pictured), Managing Partner and Portfolio Manager: “Both of these transactions were broadly syndicated to global institutional investors. We have already launched our first CLO of 2013 and expect to issue as many as four CLOs this year.”
As well as managing CLOs, these managers are increasingly tailoring their needs to institutional investors by running CLO funds, which invest in the CLOs of other third-party managers. Funds such as those managed by GSO Capital Partners International out of London are providing compelling returns, and as Markus adds: “In our absolute return vehicles, we continue to see strong demand from institutional investors, many of whom have looked to diversify their credit exposure through the use of alternative investment strategies.”
Josh Terry, Managing Director and Head of Trading at Highland, says that investor demand is strong right now “for pretty much all tranches of CLOs. We’ve seen AAA-rated securities already come in at 10 to 15 basis points this year so there’s been quite a strong rally in the liability side of the capital structure in 2013.”
2010 and 2011 were characterised by market volatility, which is ultimately the main enemy of CLO creation: without new CLO paper coming to market, funds are restricted to the secondary market. However, 2012 proved more benign and Terry postulates that 2013 could be even better, with USD75billion of CLO issuance.
CLO managers are perfectly placed to construct funds because of their innate knowledge of the loan markets.
“Being a loan investor in our absolute return funds gives us a deeper understanding of the loan market, which we believe makes us a better CLO manager. Similarly, being a CLO manager gives us additional perspective on the market, which makes us a more skilled investor in loans and third-party managed CLOs,” explains Markus.
Terry says that when investing in other managers’ CLOs the whole process is fundamentally driven: “We are unique in the sense that we have the capability to look at the underlying portfolio of loans that a CLO manager has selected and say ‘Okay, we know this percentage of loans very well, we think this percentage is going to be downgraded, this percentage will default’, and based on our underlying knowledge of the portfolio we can make an assessment of where we want to be in the capital structure of that CLO.
“Then we analyse the structural characteristics of the deal and finally we look at the manager; that’s our last consideration because we have the ability to look at the loan portfolio, monitor it, and if it deviates away from our expectations then we have the ability to sell our positions into the market.”
Mark Moffat, Senior Managing Director at GSO concurs, adding: “The important thing for us is that it all starts with a fundamental knowledge of the corporate loans backing the CLO. If we’re comfortable with the loan portfolio we then perform due diligence on the manager and make sure we’re satisfied with their credit process, resourcing, and the structure of the transaction itself.”
When you consider that each CLO will typically have around 120 companies within it, the complexities of understanding the portfolio, what the quality of loans is like in each tranche, etc, makes for a long and detailed investment process in any given CLO fund.
“A typical fund for us will hold about 30 positions across 20 or so different managers. The majority of a portfolio will be in BBB, BB-rated securities and equity positions,” confirms Terry.
Most CLO fund portfolios hold between 30 and 80 different investments in anything up to 70 CLOs. Rather like a Russian doll, a CLO fund is uniquely layered and diverse; something that investors no doubt appreciate.
“A fund that invests in a portfolio of CLOs can look through more than 1,700 different companies. We would tend to focus, given the returns that we are looking to generate, at the bottom of the CLO capital structure on CLO income notes and CLO lower rated mezzanine investments: BB, B-rated investments.
“Currently, we see the default outlook in the US as being relatively benign and therefore the risk/return balance at that end of the capital structure is more attractive,” comments Moffat.
From a performance perspective, CLO funds seem to be delivering compelling returns. It’s not unheard of for some to generate annual returns in excess of 50 per cent, although high single digit to mid-teen returns are a more approximate average.
“Our positions in CLO equity and BB tranches delivered strong performance for a number of our funds as the loan default rate remained low, cash flows to the equity tranche remained strong and increased demand from investors drove yields lower. While we believe asset spreads will tighten in the coming year, we expect liability spreads to follow suit, resulting in an attractive return profile for CLO equity investors,” says Markus.
Highland launched its CLO Value Fund I back at the end of 2008. It was expected to mature in 2014 but when the market rebounded much quicker than expected the fund ended up being monetised at the end of 2009, providing a rather healthy 138 per cent gross return to investors; that is not typical of most CLO funds but it illustrates their potential to deliver quick returns if market conditions are favourable.
“Typically, a blended portfolio of both primary and secondary CLO debt tranches – say BB and BBB – might deliver an overall return profile of mid to high single digits, on average.
“However, when you take into account that average dollar prices are close to 90 cents on the dollar in the current market, the likelihood of some spread tightening over the next couple of years could drive the investment closer to par, or the likelihood your secondary investments could be redeemed earlier than modelled and pulled to par more quickly, means that returns in the neighbourhood of 10 to 15 per cent are possible.
“2012 performance was, for us, strong across the board and our outlook is attractive for 2013 as well,” says Terry.
Markus believes that currently, the opportunity set for CLO investors has shifted away from 2005-2007 vintage CLO paper to new issue CLOs. This move, he says, has been driven by the rally in spreads over the course of 2012 and the fact that the limited supply of vintage CLO paper in the secondary market has meant that “holders are less inclined to sell. On the new issue front, we believe CLO equity continues to be attractive as investors can achieve mid-teen returns (on a loss-adjusted basis) for secured corporate credit.
“Additionally, while subordinated tranches of the CLO capital structure rallied over the course of 2012, the AAA slice remains approximately 10 basis points wider than post-crisis, making this an attractive investment for some investors.”
While returns are clearly attractive in CLO funds, they aren’t without risk. As mentioned, Highland’s CLO Value Fund I was able to close early on a fast market rebound. But that’s not always the case. Historically, this is an asset class that has gone through periods of illiquidity. Investors have to be comfortable in the knowledge that such an investment might not always deliver on time and that liquidity could deteriorate in the underlying collateral – the bank loans – at a certain point.
“There are two categories of risk for investors to consider: fundamental risk and technical risk. On the fundamental side the risk is that the default rate and loss rate in the underlying collateral is above what’s expected in the investment. On the technical side, it goes back to liquidity. You have to be comfortable with some potential mark to market volatility and periods of illiquidity when you invest.
“However, the market right now is characterised by short duration investments. The secondary market is mainly comprised of CLOs that are ending their reinvestment periods this year and in 2014. So mark to market volatility should be somewhat muted,” says Terry.
Managers like GSO Capital Partners invest in the lower, riskier end of the capital structure which might not necessarily suit every investor but Moffat confirms that presently the firm is discussing managed account solutions with some clients:
“If an investor wants solid BBB, A-rated securities then we can create tailored managed accounts at those specific rating levels. Alternatively, someone looking for a higher return-type of product could choose to invest directly into one of our funds or we could create a bespoke managed account for them in those lower rated tranches. We are seeing increased interest from investors wanting to make a single large investment in structured credit.”
As a new asset class, CLO funds are a palatable option for investors who may still have some reservations about investing directly into securitised products. But Markus adds a final word of caution:
“Over the past six months, CLO spreads have rallied significantly. Depending on the fund’s mandate, there could be concerns about managers “reaching for yield”. Separately, given the limited supply of CLO paper, it may be challenging for some larger funds to ramp up and invest all of their capital efficiently.”