Anthony Peters, SwissInvest strategist
ISN’T IT AMAZING how short collective memories can be? I recently came across an article that reported that issuance of CLOs had picked up to levels that were within striking distance of those achieved in the record year of 2007. When I say “striking distance”, I don’t mean within a few billion but certainly getting on towards a run-rate of 80% or more. How can it be, the article appeared to ask, that a product that was in the centre of the credit crisis was so vividly alive and kicking?
The alphabet soup of structured finance – CLOs, CBOs, CDOs, CMBS, RMBS, etc – takes some navigating for the uninitiated and the implied question is, on the face of it, not an unreasonable one. But the differences between those many products are profound – and important.
Take CLOs. During the heydays of structured credit, CLOs were favoured by many smart investors precisely because they were being dynamically managed by skillful and experienced portfolio managers. And for those who could bear the mark-to-market risks, they have by-and-large performed admirably.
I was this week approached by an official with one of the regulatory bodies who asked me why so few defaults had been suffered by CLOs despite the visible risks of playing around with a portfolio of leveraged loans.
My answer was simple. The purpose of the aggressive action taken by the monetary authorities in the crisis and post-crisis environment (that is, injecting surplus liquidity at no cost) was to keep the economy afloat – and companies with highly leveraged balance sheets have benefited more from the near-endless supply of next to free money than anyone else.
The benign refinancing environment duly assured that even highly geared companies remained in business, which in turn had a stunning effect on the default statistics. And, as night follows day, with defaults conspicuous by their absence, credit spreads began to contract too. It was, in other words, a virtuous circle for borrowers, managers and investors.
What will become of investors who cannot ride out the price volatility that any leveraged vehicle has built in?
THE FLOW OF new business does not, of course, point towards rampant new appetite for CLO risk but reflects existing deals maturing and being refinanced by way of new issuance, although many of the more recent transactions are sporting significantly lower leverage than their predecessors.
On the same note, most investors in the mezzanine and junior tranches will be existing and yield-hungry holders of the redeeming transactions who are happy with the outcome and who are quite prepared to roll over into new structures.
With underlying credit spreads comparable and is some case tighter than they were in 2007, the early pay-down of capital is no surprise and it creates a feel-good factor as it boosts the returns on the lower-rated tranches, especially those from the first loss or equity tranche.
Plus, with 10-year high-yield bonds in the mid-Double B space paying only 7%, the uplift from a loan-based product where recovery rates are in the high 70s (and not in the low teens) looks compelling.
THERE MAY BE, however, one fly in the ointment: the risk of underlying interest rates beginning to rise.
In other words, the very feature that has helped CLOs defy gravity – namely cheap money and plenty of it – will, when withdrawn, no doubt lead to something of a rout – and I don’t mean a simple mark-to-market one either. The virtuous circle could very quickly become vicious.
It is true that SIVs and credit conduits, which thanks to leverage could buy the top Triple A tranches at spreads as tight as 35bp and still generate triple-digit returns, have all-but disappeared as buyers of senior and super-senior tranches. But that kind of paper has simply ended up elsewhere – reportedly, often on the books of US regional banks.
That – in the words of one of my investment banking friends – could be the next shoe to drop, as bank balance sheets are not where such paper belongs.
I continue to believe in the CLO as a robust and grown-up structured product. But I do wonder what will become of those investors who cannot ride out the price volatility that any leveraged vehicle has built in, especially when headline credit markets begin to change direction.
No doubt we will soon find out.