CLOs: Should They Stay or Should They Go?
The CLO market is finishing another strong year, and many predict outsized returns (>200 bps) in the coming years. But others see alarming parallels with CDOs and last decade’s financial meltdown.
1 November 2019
Collateralized loan obligations, or CLOs for short, have been in the news a lot lately. CLOs package together high-risk corporate debt and are then sold to institutional investors seeking potentially substantial returns. Since they’re structured much like CDOs (collateralized debt obligations), which were comprised of subprime mortgages and blamed for the financial meltdown a decade ago (remember The Big Short?), some are raising concerns about a potential crisis. I pored through the news, spoke to colleagues and clients, and attended events (most notably ABS East in Miami last month) to find an answer and gain a holistic perspective on the topic.
Are CLOs fueling an impending crisis? The case against CLOs.
Eerie similarities exist between CLOs of today and CDOs of yore: The global CLO market is now between $1.4 and $2 trillion. In 2007, CDOs were $1.2 to $2.4 trillion. Low interest rates elsewhere compel investors to buy CLOs – and increased demand may lead to deteriorating credit standards for such loans.
Are credit standards deteriorating? Recently, a $40 billion chunk of leveraged loans tied to 50+ companies lost 10 bps+ in just three months. Some losses were compounded by ratings downgrades to CCC, forcing CLOs to drop those holdings (given the ~7.5 percent typical limit on CCC assets that managers can hold). At last month’s ABS East event, many expressed concern about exactly this – a downward ratings migration. With nearly 50 percent of loan collateral currently rated B/B-, they worry that the next downturn could lead to widespread downgrades and a severe spike in CCC exposure, placing both the subordinate noteholders and the equity at risk.
Media is sounding the alarm: The “Reading Between the Headlines: Addressing the Latest CLO and Leveraged Loan Market News” panel at ABS East evolved into a debate between CLO managers versus financial journalists. Adam Tempkin from Bloomberg raised the risk of a downward ratings migration: “These spikes might be at a magnitude quicker than you think in a downturn. The question is how will collateral managers deal with that … there’s going to be tremendous differentiation. This is a persistent, important risk that’s emerging and we’ll see more headlines of that going forward.” Another journalist, Will Caiger-Smith from Debtwire, cautioned: “It’s not just about the loan market, it’s about what the loan market enables in other parts of the financial markets. They enable private equity to take on much more aggressive deals …. CLOs might ride out ok like in the last crisis but that doesn’t mean every other part of the financial markets is going to be untouched.”
Pressure’s on from regulators and government officials: Sen. Elizabeth Warren’s recent letter to the SEC emphasized the CLO market’s growth, saying, “I am especially concerned about CLOs, given the rapid growth of CLOs and the lack of appropriate responses from federal agencies, including the SEC.”
Counterpoint: CLOs are not CDOs
Corporate loans, not subprime mortgages, are CLOs’ underlying debt: Today’s CLOs comprise corporate loans across a diversified set of industries. Also, according to Timothy Taylor, economist and managing editor of The Journal of Economic Perspectives, CLOs are “…less likely to be financed by short-term borrowing, and less likely to serve as collateral for short-term borrowing. Less of a connection to short-term financial markets means that the risk of a 'run' on the asset is reduced.” At that lively panel at ABS East, David Preston, managing director at Wells Fargo, said, “It’s fair to say credit has somewhat declined in the past 8 years … but I think when you make the leap to saying that we’re in another 2007 situation and it’s a systemic risk … you’re talking about a $650 billion market of CLOs which in the grand scheme of financial assets … it’s not nearly the size of where we ended up with the levered residential situation.”
CLOs are actively managed and fare well during recessions: CLO fund managers consistently emphasized this point at ABS East. Managers can make select certain credits and manage potential exposures to CCC holdings. Olga Chernova, chief investment officer at Sancus Capital Management, said, “If you look at how CLOs have fared in prior recessions they have done phenomenally well … 96% of CLO equity had positive returns and average returns of 15 percent ... being able to manage through a crisis makes a big difference.”
Some CLO sub-sectors are taking off. For example, CRE CLOs: This sub-sector contributed to the CLO market’s overall growth in the last three years. Issuance is forecast to exceed that of last year: FY 2019 issuance could exceed $19.3 billion, up nearly 40 percent above 2018’s $13.9 billion. And, performance overall is positive, with only 0.7 percent either delinquent or in special servicing as of September 2019 (Source: KBRA CRE CLO Trend Watch, October 2019).
ESG-themed CLOs are emerging—and CLOs are almost naturally ESG: Most recently, Danish firm Capital Four launched a €359M CLO. CLO fund managers can argue that their process already incorporates ESG principles. For example, governance – the G in ESG – has been factored into credit analysis for years. And the actual exposure of leveraged loans to industries that ESG avoids (tobacco, gambling, pornography, weapons and hazardous chemicals) is scarce: Exposure to non-ESG represents an average of just 3 percent of European CLO collateral.
Whether the CLO markets falter or flourish remains unknown, but investors seeking yield in an increasingly low rate, low return environment will continue to create demand. If CLOs are here to stay, the industry can draw comfort from some significant takeaways:
- How well the asset class weathered the 2008 crisis;
- Banks are now better capitalized and less leveraged;
- Rating agencies are more transparent with their approach;
- Transaction disclosure requirements are more robust compared with pre-crisis days.
Intralinks is a preferred VDR for CLOs and other structured finance transactions and supports 17g-5 reporting. Contact us to learn how our VDR technology facilitates secure, efficient, and 17g-5 compliant CLO transactions.
Sean Stack is an account executive on the banking and securities team at Intralinks in New York. Sean is responsible for assisting clients in the debt and equity capital markets with the secure exchange of information. Prior to joining Intralinks, Sean worked with corporates and financial institutions to provide a variety of deal lifecycle solutions in the credit space.