Investment strategies backed by US or European senior secured bank loans are increasingly gaining the attention of investors looking to build alternative income portfolios.
The attraction of these loans is that they are secured against assets, rank above bonds in the event of any default, and pay a floating rate of interest that is attractive in an environment where interest rates are likely to rise.
One of the key ways of accessing the senior secured bank loan market for institutional and retail investors is via collateralised loan obligations (CLOs). CLOs are the vehicles in which bank loans can be securitised.
The borrowers tend to be large US companies for which extensive financial information is available. To attract buyers and reduce the cost of financing, a CLO is divided into tranches which can be rated (up to AAA) by multiple rating agencies and issued as floating-rate notes with a fixed spread. Both loans and the financing of these CLOs are floating rate and currencies are matched.
Every quarter the CLO receives income from the loan portfolio, pays the interest due on the financing and expenses, and pays any remaining available cash (effectively its funding margin) to investors in its income notes.
The income note return is primarily a function of the manager’s ability to avoid non-performing loans in the portfolio, though CLOs typically include more than 150 loans from different companies, so the risk concentration is not as high as if an investor took the direct route and invested in a handful of loans.
CLO income notes can potentially offer investors attractive double-digit returns. The average dividend yield for the London and European-listed closed-end CLO funds was more than 9 per cent for 2014 on an annualised basis.
This excludes any further return through net asset value or share price appreciation. By way of comparison, the FTSE All-Share dividend yield was 4.39 per cent for 2014. One of the reasons these returns are so attractive is that certain market inefficiencies have created income opportunities for investors.
Liquidity, for example, is probably overpriced, and many investors have been flooding the bond markets with capital to access this liquidity. This has pushed the potential returns offered by bonds down and, comparably, loans and CLOs can offer a much more attractive return.
During the credit crisis any three-letter acronym for an investment vehicle was treated like a social pariah, and CLOs often got mistaken for CDOs (collateralised debt obligations). In fact, the loans underpinning CLOs performed strongly throughout the credit crisis and beyond.
One of the major risks for a CLO is that the loans underpinning the CLO default. But during the credit crisis the highest average default rate over five years was 3.53 per cent per annum over 2008-2012, according to the Credit Suisse Institutional Leveraged Loan Default Review. This strong performance has continued and the February monthly default rate for the S&P US Loan index was only 0.73 per cent.
US retail investors are much more aware of the opportunity for potentially attractive returns in the leveraged loan market. Up until June 2014, US funds that invest in leveraged loans had experienced 95 consecutive weeks of inflows.
Retail investors in the US have poured billions of dollars into mutual funds and ETFs that invest in these loans. Recently these inflows have reversed as the threat of rising interest rates failed to materialise.
However, demand from CLOs, which enjoy longer term funding and limited mark-to-market constraints, picked up the slack and volatility in pricing was limited.
The average UK retail investor is still relatively uninitiated about the potential returns available through investing in the leveraged loan market, either directly or through CLOs. The new funds listed in the UK market have also avoided some of the excesses seen in the US.
As the possibility of rising interest rates slowly creeps closer, this is surely an investment opportunity that should be more widely considered – especially if one is able to access the potential for uncorrelated double-digit returns.
Miguel Ramos Fuentenebro is partner of Fair Oaks Capital.
The next generation of CLO transactions issued since the market restarted in the US and Europe
The year the CLO market restarted in the US (start of CLO 2.0)
The year the CLO market restarted in Europe (start of CLO 2.0)
Volume of US market CLO 2.0 issuance in 2014
Volume of European CLO 2.0 issuance in 2014
Forecast range of CLO issuance in the US for 2015
Forecast range of CLO issuance in Europe for 2015
Source: S&P Capital IQ LCD
Source: FT Adviser