As investors hunt for yield, the CLO market is booming but can the industry keep pace with demand?

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By Robin Pagnamenta – In a world of rock bottom interest rates, asset managers are engaged in a relentless hunt for yield.

It’s one reason why the market for collateralised loan obligations (CLOs) is attracting growing attention and is now on track for a bumper year.

CLOs are effectively bundles of leveraged corporate loans chopped into tranches and sold on to investors, who benefit from higher returns and a more diversified portfolio.

Despite a wobble last year, when pandemic worries triggered a plunge in debt prices and briefly paralysed the market, the sector roared back to life this year, amid brisk demand for the instruments.

Cornerstone investment

Once viewed as a niche area of specialist investment, CLOs are increasingly being accepted as a cornerstone of many portfolios where managers are seeking inflation-hedged and stable returns.

In the US, around USD75 billion of new CLO issuance had been priced by June, putting volumes on track to hit about USD140 billion this year, according to forecasts by Bank of America.

That robust demand for CLOs is being fuelled by the healthy spreads up for grabs, raising concerns in some quarters about the ability of the broader market to cope.

So what are the main factors shaping the CLO market this year and into next? And what should investors expect from a performance perspective?

Critics fret that CLOs allow companies to take on more debt than they can afford and therefore represent a potentially risky proposition.

Others say the sector is no more risky than the regular corporate bond market and its robust recovery from the depths of the market meltdown in the spring of 2020 reflects its long-term viability.

Either way, there are more pressing concerns facing fund managers and others seeking to capitalise on the rising interest.

End of LIBOR

One issue facing market participants is the looming migration away from London Interbank Borrowed Rate (LIBOR) at the end of this year – a development with sweeping implications for the CLO market as it serves as the reference rate for hundreds of billions of dollars worth of new and historic contracts.

“What impact is that going to have for new issuances going forward, but also legacy issuances, because all of those assets are based on LIBOR, as are all the liabilities in the CLO?” says Greg Myers of Alterdomus. “I don’t know how that’s going to prevail over time.”

Another consideration is the growing role played by non-traditional lenders in the market for CLOs, which is changing the shape of the sector.

Where historically, the CLO market was dominated by big banks like Bank of America or JP Morgan, these days some of the biggest players are the debt investing arms of private equity giants like Blackstone and Carlyle.

“There’s more deals that are being done by non-bank lenders, and I’m sure their underwriting standards are just as good, but we’re seeing that shift away from banks and investment banks,” says Myers.

“Is that healthy or unhealthy for the broader market?”

Myers said he was “neutral” on the implications of this trend.

“Competition typically is good, but it’s certainly going to disrupt the traditional distribution of those assets.”

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