How CLOs can deliver high returns
20 November 2014
Investment strategies backed by US senior secured bank loans are increasingly attracting the attention of investors looking to build alternative income portfolios.
As the recent market correction has highlighted, excess liquidity has compressed yields, challenging income investors to take additional risks for a small increase in returns.
The securitisation of US bank loans as collateralised loan obligations (CLOs), on the other hand, is an example of a credit strategy potentially able to generate returns in the 10-14 per cent range for income note investors taking advantage of market inefficiencies.
At the moment, an investor is paid approximately 0.7 per cent more to invest in unsecured high yield debt instead of senior loans of a similar rating, or 4.5 per cent more to invest in CCC high yield bonds instead of BB-rated ones.
Three years ago, they would have received double these premia. Fundamentally of course, this higher yield is the price of the risk of investing lower down the capital structure or down the credit quality spectrum.
As an alternative, certain market inefficiencies have created income opportunities for investors.
Liquidity, for example, is probably overpriced. The ability to hold investments for between three and five years has the potential to enhance returns significantly.
At the other end of the spectrum, banks, money market funds, Ucits funds and other large pools of capital desperately seek highly rated, liquid debt in which to place excess liquidity. Securitisation markets can, as a result, finance certain assets to maturity on a non-recourse, non-mark-to-market basis at very attractive terms for investors.
The securitisation of US bank loans as CLOs is based on the CLOs’ ability to issue long-term (over 10 year), non-mark-to-market, non-recourse debt to finance diversified portfolios of senior bank loans to maturity.
Typically, the obligors are large US companies for which extensive financial information is available. To attract buyers and reduce the cost of financing, CLO debt is issued in tranches that can be rated (up to AAA) by multiple rating agencies and issued as floating-rate notes with a fixed spread. Both loans and financing are floating-rate and currencies are matched.
CLOs operate as financing companies: 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, not the mark to market of the loans – as, regardless of the market price of the loan, the borrower has to pay interest.
CLOs combine higher-quality, liquid US loans with efficient long-term financing to potentially offer attractive, double-digit returns, mainly driven by fundamental analysis, to investors with a longer-term investment horizon.
There are a number of managed products that offer access to this market, either in private form or as listed investment companies.
But the managers, structures, liquidity and general terms vary significantly and investors should devote some time to selecting the optimal manager and investment vehicle.
Miguel Ramos Fuentenebro is partner at Fair Oaks Capital.
A non-comprehensive due diligence list for investing in CLOs should include at least a review of the following features:
Investing in CLOs requires dedicated resources able to analyse and monitor the loans in the underlying portfolios, identifying any underperformers early. Teams should be experienced but nimble enough to be able to sell any potentially non-performing loans well before credit problems are apparent to the general market.
CLO investments are medium-term investments that require committing capital for a number of years. Some vehicles are listed on a stock exchange but many of them are ‘permanent’ – they have no maturity or redemption features. A CLO can return capital to investors after five to seven years, so a fixed maturity vehicle can take advantage of this. Receiving interest and principal as it is generated shortens the duration of the investment and avoids the reinvestment and liquidity risk present in many permanent listed investment vehicles.
When a new CLO is launched, the CLO manager will benefit from a significant amount of new assets under management and will be paid a fee for managing these assets. The investor in the CLO income note has to ensure that the CLO manager’s interests are aligned with theirs and that any fees are negotiated on an arms-length basis. Independence between the CLO manager and the investor in the CLO income note is paramount to avoid conflicts of interest.