The collateralized loan obligation (CLO) market has seen impressive growth over the past several years. CLOs attract investors with the opportunity to add exposure to the loan asset class and the ability to select various levels of risk exposure. As interest in CLOs peaked toward the end of 2018, so did the rise in covenant lite loans as investors clamored for yield. Given the current uncertainty in the market, CLOs pose a unique opportunity to investors willing to do their homework.
Aegon AM US Investing 101
|A COLLATERALIZED LOAN OBLIGATION, OR CLO IS A SECURITIZED PORTFOLIO OF LEVERAGED LOANS THAT INCLUDES A SERIES OF TRANCHES WITH VARYING LEVELS OF RISK. INVESTORS IN CLOS CAN SELECT THE TRANCHE THAT ALIGNS BEST WITH THEIR RISK/RETURN PREFERENCES.|
Investment opportunities in the CLO market
CLOs are leveraged funds with several levels of risk that an investor can select based on their risk/return preferences. Exhibit 1 reflects a hypothetical CLO new issue as it would be shown to investors looking to participate in the transaction.
Exhibit 1: Hypothetical CLO New Issue
|$45mm||Equity||Residual Cash Flow|
Hypothetical example for illustrative purposes only. Source: Aegon AM US
The senior tranches of a CLO (AAA/AA/A) are popular for banks (US, Canadian, European and Asian), life insurance companies (US, European and Asian), and large US money managers. The mezzanine tranches (BBB/BB) tend to attract an investor base reflecting large money managers, insurance companies and certain hedge funds. Finally, the most junior tranche of the stack, equity, typically has an investor base of hedge funds, business development companies (BDC) and money managers.
Our current return expectations for CLO equity investors can range from 10-12%. With reinvestment periods usually around five years, locking in the cost of debt for multiple years is attractive to equity investors as they are willing to bet that the loan market will have periods of spread widening over the life of a CLO. When loan spreads widen and the cost of debt is fixed, there can be a substantial increase in the returns the equity investor can achieve assuming losses in the portfolio are reasonable. CLOs that are duration agnostic may present the opportunity to offset the ongoing redemptions from retail funds that continue and are likely to persist as long as the Fed keeps cutting rates.
Why the CLO market is still attractive
Developed in the 1990s, the CLO market now roughly $800 billion, represents approximately 70% of the leveraged loan market. CLO issuance (new transactions excluding refinancing) in 2019 is expected to exceed $90 billion with some momentum going into 2020.
We believe CLOs are attractive because of the potential for relative value that debt investors can get versus other structured asset alternatives. Additionally, the arbitrage has to be appealing for the equity investors to aggressively bid equity tranches. When the CLO market shows attractive relative value for the debt tranches and reasonable equity returns, CLO issuance can be prolific, reaching levels greater than $100 billion per year. A secondary market emerges once a CLO is issued and the debt and equity tranches can trade on a secondary trading market. The secondary market provides some liquidity for CLO paper which is very important to many investors.
Currently, there are approximately 200 CLO managers worldwide, roughly 150 in the US and 50 in Europe. There are a wide range of managers, some of the more prominent types of CLO managers are: credits arms of private equity firms; asset management divisions of US life insurance companies; large US money managers; groups affiliated from large banks; and independent, pure play loan managers. As such, there is a wide range of CLO managers with credit and trading practices that range from conservative to aggressive. This affords CLO investors the option to select whichever manager style they prefer. Additionally, pricing of debt and equity tranches can reflect a manager's style as well as their past performance in CLO management.
CLO performance is directly related to the performance of the underlying loan portfolio, which the CLO manager actively manages over the life of the reinvestment period. Defaults, downgrades and trading losses negatively impact performance; conversely, avoiding defaults, achieving trading gains and maintaining a wide spread loan portfolio positively impact CLO performance. Therefore, managing a portfolio with less volatility than peers is an important feature in achieving good performance.
Why invest in CLOs for the long term
CLOs have come a long way since the financial crisis when we believe they were unfairly lumped in with many other structured asset classes that significantly underperformed market expectations, and as a result, it took time for CLOs to regain their appeal among many investors. In fact, they have proven to perform as expected over long periods of time. This was particularly notable during the financial crisis when, despite significant volatility and elevated defaults in the loan market, CLOs performed well and within expectations. CLO debt did see some downgrades, but senior debt tranches performed very well during that period. Additionally, there were very limited losses in CLO mezzanine tranches.
We also believe the implementation of stricter regulations since the crisis, including the Basel III and amendments to the Volcker Rule, have made investing in CLOs at all levels of the capital stack more appealing. Notably, the repeal of the Dodd-Frank risk retention regulations requiring managers to retain an interest in the fund in February of last year, has encouraged growth in the market. Current market conditions have resulted in a slower CLO issuance pace. CLO equity is challenged as the cost of debt is currently high enough to limit attractive returns after factoring in expected loan yields. In addition, there have been elevated downgrades in lower-quality loans which has made CLO issuance take a pause. We believe these issues are not permanent and will be corrected over time.
Investors should, however, be prepared for periods of time with little or no issuance of CLOs due to changes in market sentiment and fundamentals. Since CLOs are under stricter regulations and there is a growing following of a wide variety of investors worldwide, we believe this asset class has the potential to thrive for many years to come.
Past performance is not indicative of future results. This material is to be used for institutional investors and not for any other purpose. The enclosed information has been developed internally and/or obtained from sources believed to be reliable. This material contains current opinions of the manager and such opinions are subject to change without notice. Aegon Asset Management US ("Aegon AM US") is under no obligation, expressed or implied, to update the material contained herein. This material contains general information only on investment matters; it should not be considered a comprehensive statement on any matter and should not be relied upon as such. If there is any conflict between the enclosed information and Aegon AM US Form ADV, the Form ADV controls. The information contained does not take into account any investor's investment objectives, particular needs, or financial situation. Nothing in this material constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate to you. The value of any investment may fluctuate. Past performance is not indicative of future results.
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Aegon AM US may trade for its own proprietary accounts or other client accounts in a manner inconsistent with this report, depending upon the short-term trading strategy, guidelines for a particular client, and other variables.
There is no guarantee these investment or portfolio strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest over the long-term, especially during periods of increased market volatility.
Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect theprepayment of bank loans and such prepayments cannot be predicted with accuracy. There is no guarantee that the liquidation of any collateral from a secured bank loan would satisfy the borrower's obligation or that such collateral could be liquidated if necessary.
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