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Fixed-Income Insights

The so-called Volcker Rule has created potential opportunities in the CLO market.  

For Institutional Use Only

 

In Brief

  • 'AAA' rated tranches in the collateralized loan obligation (CLO) market are paying more attractive spreads1 than comparably rated securities in other segments of the structured finance arena.
  • These attractive spreads have resulted, in part, from confusion about the final form of the so-called Volcker Rule, which restricts the types of investments banks can make for their own accounts and how it will apply to CLOs.
  • Unlike collateralized debt obligations (CDOs), CLOs survived the financial crisis of 2008–09 without major losses, according to Standard & Poor’s. In fact, Standard & Poor’s reports that between 1994 and 2013, of the 6,141 tranches rated by the credit rating agency, only 25, or 0.41%, defaulted.
  • In the short term, holders of CLO debt may benefit if interest rates rise gradually.
  • A proposed risk-retention rule, which could require CLO managers to own 5% of each portfolio they manage, could eliminate smaller players, putting pressure on CLO issuance. 

 

The effect of the Federal Reserve’s low-interest rate policy on the economy’s performance has been the subject of some debate, but there’s little argument that it has produced at least one result: higher asset prices. Both the S&P 500® Index and the Dow Jones Industrial Average have hit new highs, and in many fixed-income markets as well, valuations are stretched.

This makes managing assets more challenging, though it is still possible to achieve acceptable returns.  But instead of hitting “triples” and “homeruns,” portfolio managers are looking for “singles” and “doubles,” said Rob Lee, Lord Abbett Partner & Director of Taxable Fixed Income. 

One area that investors are getting hits in is collateralized loan obligations (CLOs). More specifically, ‘AAA’ rated bonds of this market continue to offer value, especially versus comparably rated asset-backed securities (ABS), according to Kewjin Yuoh, Lord Abbett Partner & Portfolio Manager of Taxable Income, who has been managing structured product portfolios for 20 years. “As other [fixed-income] asset classes have tightened over the past year, ‘AAA’ CLO spreads have not tightened materially. So, there is potential relative value versus these other asset classes,” he said.

What exactly is a CLO? (See sidebar, “CLO Basics.”) Like other structured products, such as asset-backed and mortgage-backed securities (MBS), a CLO takes a pool of assets and transforms them into instruments with a range of risk-return characteristics.  It does this by slicing the pool into classes, or “tranches,” that come with varying levels of protection. These tranches receive credit ratings ranging from low risk/return (‘AAA’) to high risk/return (‘B’). The CLO’s structure includes an unrated equity note as well, which is the riskiest, but potentially most rewarding, tranche.

A Hitch in the Market
One opportunity in the CLO market centers on the highest-rated tranches. Large banks, which had been big buyers of these bonds, have backed away because of uncertainty about the so-called Volcker Rule. Passed as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010, the Volcker Rule restricts the types of investments banks are allowed to make for their own accounts. But regulators have stumbled trying to turn sometimes imprecise language in the legislation into concrete prohibitions, leading to delays in implementation and to confusion about which investments would and would not be restricted.

As a result, banks have been cautious, and spreads on ‘AAA,’ or senior, CLO tranches have widened over the past year, while spreads on comparably rated tranches of other structured products have narrowed or remained flat. (See Chart 1.) Top-rated CLOs were paying the London Interbank Offered Rate (LIBOR) plus 157 basis points (bps), as of December 9, 2014, up from 149 bps a year earlier. Comparably rated credit card ABS securities were  paying LIBOR plus 30 bps, even with a year earlier, and ‘AAA’ rated commercial  mortgage-backed securities (CMBS) were paying LIBOR plus 83 bps, down from 95 bps. (Yield data from J.P. Morgan.)

 

Chart 1. Spreads on ‘AAA’ CLOs Have Widened Over the Past Year
Yield spreads, January 2, 2013—December 9, 2014

Source:  J.P. Morgan.
Past performance is not a reliable indicator or a guarantee of future results. The historical data shown in the chart are for illustrative purposes only and do not represent any Lord Abbett mutual fund or any particular investment.

 

Demand for senior tranches has also been crimped by regulations from the Federal Deposit Insurance Corporation (FDIC), implemented in April 2013. The FDIC requires that the nation’s biggest banks designate even the relatively safe ‘AAA’ rated CLOs they own as “higher risk,” and to hold more capital against them.2

Another regulation, passed as part of the Dodd-Frank bank reform bill, may upset the market further by requiring CLO managers to own 5% of each CLO they manage. Regulators are expected to complete this proposed risk-retention rule soon.3 A survey by the Loan Syndications and Trading Association showed that asset managers believed the proposed regulation could reduce the U.S. market for CLOs by 75%, according to Bloomberg.4   

But it is the Volcker Rule that has thrown a monkey wrench into today’s CLO market. By impeding one group of potential buyers, the rule has bollixed up the deal-making process. With securitized products, different tranches appeal to different investors. Large banks have been the predominant buyers of senior tranches, life insurance companies often buy “mezzanine” tranches, rated ‘AA’ and ‘A,’ and hedge funds are usually the investors in “subordinated” tranches, rated ‘BBB,’ ‘BB,’ or ‘B,’ and in the unrated equity tranches.5

So, if one of these investor groups pulls back, the structure of the entire CLO is affected, making it difficult to put deals together, said Yuoh. “Banks have been buying the ‘AAA’ tranche at a price of LIBOR plus about 150 bps. If they are not there to buy this tranche at that price, then a higher spread has to be offered. But if the ‘AAA’ tranche receives more, that means that lower tranches have to receive less,” Yuoh added. This, in turn, can affect how willing other investors are to buy these lower tranches.

Returns to the equity tranche, in particular, depend heavily on the deal’s funding costs, which are determined when a deal is structured. Equity returns are determined in part by the difference between the spreads paid on the CLO’s liabilities and the interest rates received from the assets (underlying loans). If ‘AAA’ tranches are in less demand, then the spread offered on those tranches may widen, resulting in higher funding costs, assuming that the spreads offered on other tranches don’t decline. Since the top-rated tranche is the largest, it can affect funding costs significantly.

The Volcker Rule takes effect in July 2015, but for CLOs owned before the rule was finalized (December 2013), compliance is not required until July 2017. The market has responded to the rule by creating CLOs that are Volcker Rule-compliant. This, combined with the proposed risk-retention rule, has resulted in a boom, as issuers have rushed to beat the prospective regulation. In fact, J.P. Morgan expects issuance in 2014 to reach a record $100 billion.6    

CLOs, Not CDOs
While regulatory confusion has contributed most to the wider yield spreads on ‘AAA’ CLOs, concerns about structured products in general may also be responsible. CLOs do not have a deep investor base, so many may not be familiar with the asset class, and they may even confuse it with the more notorious collateralized debt obligations (CDO), which played such a large role in the financial meltdown of 2008–09.

But unlike CDOs and other structured vehicles, CLOs survived the crisis with almost no damage. Holders of CLO securities—even the lower debt tranches—escaped largely without losses, according to Yuoh. This is one reason the CLO market has bounced back, while the CDO market remains far below pre-crisis levels.7

In fact, CLOs have a long history of low default rates. According to a study published by Standard & Poor’s (“Twenty Years Strong: A Look Back At U.S. CLO Ratings Performance from 1994 Through 2013”), of 6,141 tranches rated by the credit ratings agency, only 25 have defaulted in the past 20 years, and none of those were rated higher than ‘A.’ (See Table 1.) Similarly, a report by Moody’s Investor’s Service, of 719 U.S. CLOs rated by the ratings agency between January 1996 and May 2012, only 14 lost any principal at maturity, according to Bloomberg.8

 

Table 1. Total CLO Tranche Defaults Over 20 Years Amount to Less Than 1%
U.S. CLO defaults and losses by credit rating, 1994–2013
Source: Standard & Poor’s.

 

The Outlook: Rising Rates Could Benefit CLO Debtholders
With interest rates expected to rise and a risk-retention rule potentially on the horizon, what’s the outlook for CLOs? In the short term, this year’s boom in CLO issuance could keep spreads on ‘AAA’ tranches from tightening much from current levels. In addition, if rates were to rise quickly, but investors expected a downturn in the economy, these spreads could widen, said Yuoh. But if interest rates rise gradually, beginning in 2015, because of strength in the U.S. economy, these spreads may tighten, he added.

Rising interest rates are likely to benefit ‘AAA’ and other debt tranches at the expense of equity tranches, Yuoh said. As LIBOR rises, these bonds, which pay LIBOR plus a spread, will receive larger payments. Distributions to the equity tranche, however, will be squeezed because the payments coming from the underlying loans won’t rise until LIBOR exceeds their LIBOR floor. Equity holders may recover this later when LIBOR exceeds the LIBOR floor.  (See sidebar, “CLO Basics.”)

Equity investors have been benefiting from LIBOR floors since short-term interest rates went to near zero. In a study of 200 CLOs with outstanding debt as of February 18, 2014, J.P. Morgan found that equity tranches of CLOs (without ‘B’ tranches) issued between 2011 and 2012 posted average annualized returns in the mid-teens. Those with ‘B’ tranches (and greater leverage) returned 26% and 20% in 2011 and 2012, respectively.9 In contrast, with the exception of convertibles, high-yield, and floating-rate loans, returns in most fixed-income sectors in 2013 were minimal or negative.10 If returns to equity holders are squeezed by higher interest rates, CLOs could become less attractive to equity investors, potentially resulting in less issuance.

Longer term, the outlook appears a bit murky. While the CLO market has adapted quickly to the prospect of the Volcker Rule, the proposed risk-retention regulation could have a larger impact. Requiring CLO managers to own 5% of their CLOs could eliminate many smaller managers, since they may not have enough capital to comply. This could reduce the supply of new CLOs, putting the existing supply in greater demand.

 

SIDEBAR

CLO Basics
Collateralized loan obligations (CLOs) typically consist of pools of 100 or more corporate loans rated below investment grade. These loans usually have a maturity of seven years and pay a floating interest rate. The coupon rate pays a spread over the London Interbank Offered Rate (LIBOR) that varies with the loan’s credit quality.

The pool of loans is usually sliced into categories, or “tranches,” rated from ‘AAA’ to ‘BB’ or ‘B’ by credit ratings agencies such as Standard & Poor’s or Moody’s Investors Service. The top-rated tranche is the largest and accounts for a majority of the capital structure. The lowest tranche is unrated and is considered equity; it carries the highest risk and usually makes up 8–12% of a CLO’s capital. For investors in the equity tranche, the appeal lies in the possibility of higher returns that are made possible by the use of leverage.

Higher-rated tranches achieve their ratings, in part, by virtue of subordination in the CLO structure. Subordinated tranches protect higher-rated tranches by being the first to take any losses that burn through a CLO’s credit enhancements (see below).

Table 1 shows the structure of a hypothetical deal. The assets consist of 150 loans totaling $500 million in par value. The average credit rating is ‘BB’/‘B,’ and the average “all in” spread (which includes the LIBOR floor), weighted by loan value, is 390 basis points (bps).

The liabilities consist of six debt tranches totaling $471.7 million and an equity tranche worth $43.15 million, for a total of $514.85 million. Tranche A is the largest and is protected by “par subordination” of 37.5%. That is, at $312.7 million, this tranche is backed by 62.5% of the underlying loans ($500 million par value), leaving the remaining loans (37.5% of the $500 million) to provide a buffer, all of which have to default before Tranche A experiences a loss. Similarly, Tranche B, at $62.5 million, is backed by 12.5% of the par value of underlying loans. Together, tranches A and B are collateralized by 75% of the loan pool, leaving the remaining 25% as a buffer. All of this buffer must default before Tranche B suffers a loss. Subordination levels decline with each step down the capital structure until the equity tranche is reached. It enjoys no subordination and is the first tranche to take any losses that occur.

 

Table 1. A Hypothetical CLO Deal 

Source of data:  J.P. Morgan, Lord Abbett. The hypothetical portfolio is for illustrative purposes only, does not represent any funds or any products managed by Lord Abbett, and is not indicative of any specific investment.
* Discount margin reflects the coupon rate and the extra yield that is earned by buying the security at a discount and holding it to maturity.
Ɨ The weighted average spread is the average spread on a group of loans, weighted by the size of each loan. In this table, the weighted average spread is “all-in,” meaning that LIBOR floors are included.
**For the liabilities, the weighted average spread is the average spread over LIBOR, weighted by the size of the tranche.

 

Each debt tranche offers a spread over LIBOR, which ranges from 145 bps to 615 bps, depending on the credit rating. The discount margin on each tranche reflects the spread over LIBOR as well as the effect of purchasing the respective security at a discount from par.

As mentioned above, CLOs also come with credit enhancements. For example, the debt tranches are “overcollateralized,” meaning that the value of the assets (underlying loans) exceeds the value of the liabilities issued by the CLO. In the example above, $471.7 million in liabilities is backed by $500 million in assets. This provides a degree of protection to even the lower tranches. Similarly, various interest coverage tests ensure that the underlying loans pay more in interest than is necessary to make payments to the various tranches. Another protection, a “diversion trigger,” diverts cash flows from the equity tranche to the senior tranches if the underlying loans begin to weaken.  

The first four years of a typical CLO make up a reinvestment period during which the loan portfolio is actively managed, allowing the manager to buy and sell loans. After the reinvestment period, trading is more restricted. 

As loans are paid off, principal payments are made to debt holders, with payments going to ‘AAA’ tranches first. As the loans are paid off, cash flows to the equity tranche begin to decline. Why? Because the difference between what the CLO pays on the liabilities and what it receives from the assets becomes narrower. The ‘AAA’ tranche is the “cheapest” source of funds and is paid off first. As each tranche is paid off, the funding costs rise and the margin between the cost of the funds and the interest received on the loans becomes narrower. 

As cash flows decline, returns to the equity tranche are reduced and may no longer be enough to justify keeping the CLO active. This is when owners of the equity tranche, who have call rights on the CLO, will often exercise those rights. When the liabilities are called, the CLO is liquidated, and principal is returned to remaining investors.

Equity tranche investors have benefited from low LIBOR rates since the financial crisis. Coupons paid to CLO investors have been relatively low while cash flows coming from the assets (loans) have remained relatively high. The latter have been high by comparison because the underlying loans come with LIBOR floors, which have prevented the coupon from falling below an agreed upon level, consisting of the floor (75–100 bps in today’s market) plus a spread. For example, if the floor is 100 bps, or 1.00%, and the agreed-upon spread is 400 bps, then the borrower would pay 500 bps, or 5.00%, as long as LIBOR remains below the floor. So, because LIBOR (currently 25 bps) is below the floor, the borrowers have been paying the floor rate plus the agreed-upon spread. 

The benefit of the LIBOR floors to the equity tranche will diminish as LIBOR rises, however, said Yuoh.  That’s because the coupons paid to the various tranches will rise, but the coupons paid by the loans will remain fixed at the LIBOR floor plus a spread until LIBOR rises above the floor. In the meantime, as the last column of Table 2 shows, the extra cash that flows to the debt tranches as LIBOR rises will likely come at the expense of the equity tranche. Equity holders may recover this later, however, when LIBOR exceeds the LIBOR floor. When this occurs, the coupons on both the liabilities and the assets will rise equally, but since the assets are greater than the liabilities, the extra cash generated by the assets will flow to the equity tranche.

 

Table 2. The Benefit to the Equity Tranche from LIBOR Floors Initially Declines When LIBOR Rises

Source: Lord Abbett.
Data are hypothetical and for illustrative purposes only.

 

1 “Spreads” refer to the interest rate spreads over the three-month London Interbank Offered Rate (LIBOR).
2 Kristen Haunss and Christopher DeReza, “New York Life Sells CLO with Lowest Yield Spread on AAAs of 2014,” www.bloomberg.com, June 5, 2014.
3 Sarah Husband, “New CLO Managers Start to Appear in Europe, Continue to Ramp in U.S.,” www.forbes.com, July 2, 2014.
4 Kristen Haunss, “CLO Issuance Eclipses 2012 with $57.1 Billion Raised, Fitch Says,” BloombergBusinessWeek, November 8, 2013.
5 Neil O’Hara, “CLOs: Firing on Three Cylinders,” www.ftseglobalmarkets,com, October 13, 2013.
6 Kristen Haunss, “J.P. Morgan Sees Record $100 Billion in Loan Funds,” www.bloomberg.com, June 4, 2014.
7 O’Hara, op cit.
8 Haunss, op cit.
9 U.S. Fixed Income Markets Weekly, J.P. Morgan, June 6, 2014.
10 J.P. Morgan, Guide to the Markets, 3Q 2014.

 

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