Collateralized Loan Obligations Flourish: A Case of Déjà Vu
Category: Investment Research
The alphabet soup associated with the Global Financial Crisis has resurfaced as CLOs and CDOs once again make headlines. Collateralized Debt Obligation (CDO) securitization, a process of pooling loans and dividing up the cash flows along tranches, was pinpointed as the culprit that turned a typical risk asset decline into a systemic global crisis. Since 2008, mortgage securitization has crawled to a halt--with the exception of the highest quality government-backed loans. Securitization has flourished in corporate debt markets, however, with record issuance of Collateralized Loan Obligations (CLOs) causing déjà vu.
Is History Repeating Itself?
CLOs have raised concerns due to their parallels to subprime mortgage CDOs: a similar securitization process, a comparable market size, and low skin in the game from issuers. Some CLO and bank loan investors stretching for yield have accepted issuer-friendly terms at yields that do not compensate investors for the underlying risk. These are all reasons to be vigilant about CLO exposure. However, CLOs are unlikely to cause the type of systemic risk posed by mortgage CDOs.
CLOs Warrant Caution, Not Panic
CLOs have stronger assets and transparency in our view. The syndicated bank loans that comprise a CLO are typically underwritten by highly regulated banks and the borrowers are publicly traded companies that issue audited financial statements. Mortgage CDOs, in contrast, were opaque vehicles consisting of thousands of loans that were packaged and re-packaged until investors were unable to understand their exposures and risks. CLOs are relatively comprehensible as they consist of 100 to 300 loans that are vetted by institutional investors.
Investors are not immune from volatility, but--unlike 2008-- they should have better insight into the exposures and risks of CLOs. Managing credit risk is essential for CLO performance as the rising use of covenant light loans, EBITDA add-backs, and leverage over 5x urge caution. Borrower-friendly terms may depress the default rate and allow struggling companies to kick the can down the road but would likely also hinder the recovery rate for bondholders. Given these risks, the onus is on investors to be selective in their exposure.
Healthier Market Backdrop
Market circumstances are more reasonable, as there is significantly less leverage in the ecosystem across both issuers and investors. Stricter bank regulations and lessons learned from 2008 have resulted in meaningfully lower use of warehouse financing, bridge risk, and total return swap lines. CLOs inherently use leverage, but the capital structures now have a larger cushion for losses given more junior capital than prior to the Global Financial Crisis.
Bank exposure to toxic securities in 2008 propelled a housing downturn into a banking crisis. Since then, banking system leverage has declined as Dodd-Frank and Basel III regulations have enacted stringent capitalization and risk-weighted asset rules. US banks hold about $90 billion in CLO exposure according to the Federal Reserve, but it is typically limited to the most senior AAA-rated part of the capital structure, which has never been impaired. The junior part of the CLO capital structure is primarily held by sophisticated investors including the CLO issuers themselves, hedge funds, and private credit funds. These investors are typically more comfortable with volatility and illiquidity.
Technical Risks Drive Potential Tactical Opportunities
However, redemptions could force hedge funds and open-ended funds to sell at uneconomic levels, which would potentially weaken sentiment and be a drag on asset prices. Technical risks may be especially pertinent post-2008 as market liquidity has declined, debt issuance has soared, and low interest rates have pushed investors into riskier investments. Brief examples like 4Q18 offer a glimpse into how quickly and powerfully a credit dislocation can occur.
It is best to be cautious given these risks and the late cycle environment. We do not see attractive risk/reward characteristics at this time in par bank loans or CLOs; especially the junior debt and equity tranches. Athena prefers taking a tactical approach based on the market opportunity rather than having broad exposure to bank loans and CLOs. Our structured credit managers have been impressive at managing exposures through the economic cycle and we will continue conversations with them to inform our tactical view.
For a full analysis of the topic, please see the accompanying landscape review, Securitization Revisited.