How CLOs, Despite Seeming Risky, Got to Be So Popular
In a triumph for structured finance, these packages of junk loans have up to now confounded any perils.
Art by Brian Scagnelli
Maybe sometimes you can walk on the wild side without much danger. Investing in junk-rated companies is an inherently risky move, right? Yet through Wall Street financial engineering, one type of below-investment-grade vehicle is able to dodge the nasty hazards that threaten investors in speculative credits—namely, defaults and, more recently, higher interest rates. At least that’s been true up to now.
We’re talking about collateralized loan obligations (CLOs), which are receptacles of low-grade loans. They have become very popular among institutional players.
Thanks to the legerdemain of structured finance, these creatures offer relatively high yields, and also are largely protected when borrowers don’t pay their interest, or when inflation sends interest rates higher and principal values lower. In 2021, CLO sales reached a new record, an estimated $186 billion. That showing blasts past the previous peak, 2018’s $129 billion, says Leveraged Commentary & Data.
While CLOs at a casual glance seem to have precarious underpinnings, their safety record has won them legions of fans over time. “They are a solid asset class,” said Anjela Traboulsi, senior analyst at Informa Global Markets.
At their heart, CLOs are large pools of what are called leveraged loans, which highly indebted companies take out from major banks and Wall Street firms. After gathering a batch of lev loans into CLOs, their managers sell the pools to large investors. CLOs, which began in the 1980s, have gradually found favor among institutional asset owners, with insurers at the top of the list (33% of the sector, as of 2018) and pension plans slowly getting aboard, with just 6.6%, a Federal Reserve study shows.
Their sales suffered in the 2008-09 global financial crisis and the early 2020 pandemic recession. But not because their underlying loans went bad. Simple fear was the catalyst, which proved unfounded in both instances for CLOs.
Other such structured packages invest in a plethora of debt products. Outside of mortgage-backed securities (MBS), CLOs compose the biggest securitized credit sector in the US, far eclipsing those of other asset-backed securities (ABS), in particular collections dedicated to credit cards, student loans, and auto borrowings. The CLO loan pools have $850 billion outstanding, per the Securities Industry and Financial Markets Association (SIFMA).
Sage Structures, Wonderous Waterfalls
The alchemy of the CLO structure, which makes these offerings safer and more inflation/rate-resistant than many other asset classes, has won widespread plaudits for its cleverness. Key to this is that CLOs are sliced into separate tiers, known as tranches, each with its own risk level and returns regimen.
That’s how their creators are able to transform lev loans—which are junk-rated—into investment grade. Or at least the upper tranches get that promotion. That’s due to concentrating much of the risk in the lower end of the tranche layer cake. Investors can buy a AAA tranche, at the head of this stack, which pays less and is less risky, or they can opt for lower tiers, with increasingly higher risk and returns the further down they go. “You can pick your spots,” observed Advisors Asset Management’s president and CIO, Cliff Corso.
Depending on the tranche of CLOs an investor buys, yields range from 2% to 4%. That’s better than 10-year Treasurys (1.8%), and competitive with investment-grade corporate bonds (average: 2.5%) and junk bonds (4.6%). In total returns (yield plus appreciation), CLOs romped, returning as high as 9% last year. Meanwhile, the investment-grade index, the Bloomberg US Aggregate, lost around 2% and high-yield bonds were up only 4% in 2021.
CLOs often have seven-year maturities and package some 150 loans each. This gives them the advantage of diversification and also a canny distribution mechanism called the “waterfall.” So, someone owning the AAA tranche has the biggest claim on cash flow disbursements from interest payments, maturing principals, or asset sales. If a default occurs, the damage is felt at the lower tiers, like water flowing downward.
The lowest of them all is the “equity” tranche, which has no loans assigned to it, is last in line for distributions, and is the first to get slammed by defaults. On the bright side, equity-tier investors are compensated with yields than can reach into the teens.
Perhaps CLOs’ biggest selling point in a reflation era is their floating rates, so investors won’t see their returns eaten away. CLOs are “defensive when interest rates rise,” said Jim Schaeffer, global head of leveraged finance at Aegon Asset Management.
As a result, CLOs feature low duration, which means rate hikes don’t harm their prices much, if at all. Also helping out: CLO managers have the ability to shed underperforming loans in favor of better ones.
What’s more, CLOs don’t find defaults much of a problem, especially these days, as corporate revenue and earnings have soared lately. The lev loans that make up CLOs had US defaults amounting to just 0.4% in 2021, as tracked by the S&P Global Ratings’ Leveraged Loan Index. That’s a smidgen better than junk’s record, 0.5%. (Half of all lev loans are packaged into CLOs.) “The higher-rated tranches have never been impaired,” said Advisors Asset Management’s Corso. Problems in the lower tranches have been few, he added.
It’s in times of trouble that CLOs have really earned their keep. In economically rocky 2020, their underlying loans’ US default rate was only 3.8%, while junk’s was close to 9%. In the 2008-09 financial crisis, lev loans’ default rate maxed out at 4.6%, and the junk non-pays topped 11%. A big plus for CLOs is that their loans are secured and rank high on the credit spectrum. Thus, in bankruptcy, owners of these loans will be paid before most other creditors. “CLOs held up well in the crisis,” Corso said.
CLOs’ floating rate coupons and their waterfall structure are very appealing, said Charles Van Vleet, CIO of pension investments at Textron, who has 1% of his private equity portfolio in these instruments. He prefers the equity tranche of CLOs because they pay the most yield and, although they are the first to feel the brunt of any defaults of individual loans in the pool, they benefit from CLOs’ reassuring history of low delinquency.
Up ahead, CLO yields are to be linked to the new Secured Overnight Financing Rate, or SOFR, which now runs just under 0.5%. Up until year-end 2021, CLOs used the scandal-tarred London Interbank Offered Rate (LIBOR), which came into ill repute after traders at large banks manipulated the benchmark by submitting bogus data. US regulators are mandating a switch to SOFR by next year. The transition to the new benchmark from the old one could run into trouble due to disruptions from the Omicron variant, Bank of America has cautioned.
What Could Go Wrong?
The vaunted stability of CLOs rests on really, really horrible economic times not coming to their door. The pools didn’t suffer much in 2020, with its quick (two months) recession and massive government aid to the economy, nor in 2008-09, where the bloodshed was concentrated in lousy mortgages. What if something like the Great Depression or even a lesser but still vicious downturn were to pounce upon the world? Then, business failures would be vast, to the detriment of investors who hold those low-grade company loans.
CLOs specialize in “troubled businesses, which no longer qualify for traditional banking loans,” warned a research paper by asset manager Zerocap. “Not only is the setup doomed to crash, but some of the world’s most influential banks are heavily exposed to varying levels of CLOs.”
Then there’s the question about how accurate the CLO tranche ratings are. A study by two finance professors, Jordan Nickerson, now at the University of Washington, and John Griffin, from the University of Texas, took a skeptical view of what they saw as a mismatch between the underlying loans and the higher-rated CLO tiers. Ratings agencies may be upgrading some of these top-tranche loans without the analytical rigor they deserve and potentially using more subjective criteria, the academics wrote.
Plus, they suggested, maybe CLO managers are using window dressing, for instance by populating the pools with less-risky short maturity loans—and later on, after the tranches’ ratings designations are done, replacing them with less desirable, longer-term credits.
Certainly, a CLO system failure would require an enormous cascade of corporate bankruptcies, which would wipe out everything in companies’ capital structures, from unsecured debt all the way up to the secured loans that make up CLO packages. Despite all the economic turmoil since CLOs appeared in the 1980s, nothing like that has occurred … yet. But at some point, yes, it’s possible that the nightmare scenario could come true.
Meantime, CLOs enjoy great favor in the investing world, owing to their shiny features.
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