Should You Worry About CLOs in Your Funds?
Cracks in the underlying bank-loan market are spawning worry over this market.
Should you worry about collateralized loan obligations in your funds? The short answer is probably not.
As a reminder, CLOs are securities backed by pools of leveraged bank loans. Like many structured products, CLOs are sliced up into tranches with different levels of subordination so that higher-rated tranches are protected from loss by lower-rated pieces that will suffer first when there are defaults among underlying loans. Collateralized loan obligations also have managers who are responsible for assembling the pool, and usually reinvest the portfolios over a certain period when loans are repaid.
Collateralized loan obligations aren’t the same as bank loans, and there are important reasons to differentiate between the two, but there’s no question that cracks are showing in the underlying bank-loan market. One reason for this is simply the explosion of loan issuance. The underlying leveraged-loan market has grown to roughly $1.2 trillion, up from a post-crisis low of around $500 billion in 2010, according to S&P. Among the numerous reasons is pull from the CLO market itself, which has absorbed huge chunks of loan supply in recent years. That has run parallel with companies relying more on bank loans compared with other debt. Many now carry entire debt loads in loans, leaving little, if any, lower layer in their capital structures to absorb losses. On average, loans have continued to produce better post-bankruptcy recoveries than bonds, at between 60% and 70%, but they’ve been doing so at lower rates overall in recent years and any growth in defaults among loan-only deals will almost certainly test those norms. Meanwhile, hot demand for all of that supply has led to an erosion of underwriting standards, including the growth of so-called “covenant-lite” loans carrying fewer lender protections. The implications of that are a matter of debate, but reports suggest that covenant-lite loans recently composed more than 80% of all new issuance.
But even though CLOs are built on bank loans, the chance of CLOs blowing up in the way other sectors did during the financial crisis is remote. Unlike some securitized sectors that suffered from massive principal losses, CLO structures proved more resilient during the crisis, and they’ve benefited from structural improvements since then. Today’s CLOs, loosely referred to as CLO 2.0, have a more robust design than those of the 1.0 vintages. The latter commonly carried larger highly rated tranches, so the layers of lower-quality pieces ready to absorb losses in the event of loan defaults were meaningfully smaller than those of today’s CLOs. There are more nuanced features as well, including a tendency to hold fewer of the junkiest deals and nonloan holdings. Today’s loan market also isn’t as exposed to the multitude of related synthetic derivatives that dragged down the sector during the global financial crisis, and it’s extremely rare to find derivatives linked to loans in mutual funds today.
PGIM’s portfolios are among the largest holders of CLOs among taxable-bond funds, and the firm has cited compelling data in explaining why. Even if underlying loan recoveries were only 40%, for example, it would still take an annual default rate almost twice that observed during the global financial crisis to trigger principal losses in a typical modern-vintage AAA tranche. FPA New Income’s managers have worked under similar logic and look at the issue in terms of time. In part that means focusing on tranches with average lives of three to four years--which helps minimize exposure to spread volatility--and short or expiring periods during which CLO managers can reinvest. It also means projecting how a CLO holding would perform over 12 months following a massive sell-off, and only buying if the expected return is positive. PIMCO focuses its modest exposures across funds on shorter-average-life pieces, as well.
To the degree that funds are exposed to risk in holding CLOs, it’s likely more about market technicals, liquidity, and price volatility. When it comes to those factors, who else buys CLOs is an important issue. Big institutions in Japan have been voracious buyers whose demand has reportedly been critical, particularly at times when issuance has waned. Japanese banks have at times reportedly been responsible for buying as much as half to three fourths of new AAA CLO issuance. Estimates of their holdings diverge depending on how the market is sliced up, but data from the Nikkei Asian Review suggest that a subset of five Japanese banks alone holds somewhere between 15% and 25% of outstanding CLOs. Whenever questions arise about whether and how much they’re planning to buy in the new issue market, deal flow reportedly slows to a crawl.
Most CLO investors are considered buy-and-hold types--including the Japanese banks—but it’s an open question how well the secondary market for CLOs will fare if the underlying loan market deteriorates, even in the absence of meaningful default risk to higher-rated tranches or exogenous pressures on the market. Trading among CLOs is already relatively light when compared with other bond-market sectors, and that’s not likely to improve during the throes of a market sell-off. The data are fragmented, but depending on which metrics or sources you use, daily trading has historically run somewhere between $75 million and $150 million per day overall in recent years.
What does that mean for mutual funds? To be clear, we have yet to hear CLO liquidity concerns from many fund managers. One reason is that highly rated CLO tranches usually carry modest weighted average lives, which cuts down on risk compared with longer-maturity holdings. Meanwhile, managers who have focused on CLOs over the past couple of years have argued that they’ve done so based on fundamental valuation decisions and longer-term expectations for risk-adjusted returns. One of the best lessons from past crises, though, is that even if niche sectors don’t suffer catastrophic principal loss, they can still suffer price volatility when market liquidity dries up. Investors should train a skeptical eye on concentrated exposure to any niche structured credit sectors, regardless of underlying safety. It’s also worth noting how much of this conversation has revolved around highly rated securities. Most mutual funds don’t dip into the lower tiers, but investing further down the capital structure among mid- and below-investment-grade rated tranches can be particularly risky on multiple fronts. Liquidity will almost certainly be a problem in a crisis, and of course the protections afforded to investors in higher-rated tranches are directly linked to the risk of principal loss for those holding lower-rated pieces.