Asia’s institutional investors are increasingly keen to get into private debt, in particular collateralised loan obligations (CLOs). But while this field looks set to grow, along with institutional investor demand, it could offer aspiring investors challenges, not least of which is falling yields and loosening covenants.
Experts say large institutional investors from Asia such as sovereign wealth funds and banks have lapped up new CLO issuances in the US, the largest market for such leveraged loans.
CLOs are financial vehicles that hold packages of ‘leveraged loans’ that have been sliced into different levels of risk. The vehicles use these debts as collateral to issue bonds at different ratings and yields, based upon the riskiness of the underlying loans.
The instruments are ranked from ‘AAA’ down into single ‘B’ tranches and even into equity tranches. Returns can vary from around 2.8% in ‘AAA’ tranches up into the teens for the lowest ranked portions. That’s very enticing at a time when most bonds are low yielding.
Interest from Asian investors has helped support a surge in supply this year. Credit rating agency Standard & Poor’s (S&P) said leveraged loan issuance was $512 billion for the first nine months of 2017, over $160 billion higher than the same period of 2013, the previous peak.
However, the popularity of these products led S&P’s report to warn that US leveraged loans are beginning to look vulnerable to shocks, as investors buy riskier tranches and being willing to accept weaker safeguards. Some CLOs are also being based upon loans in upcoming (but also relatively untested) industries such as financial technology companies.
It’s not known how well they will hold up in an economic downturn or outright recession.
Need for return
CLO investing engenders starkly contrasting views from investors. Some shiver at memories of the role that credit debt obligations (CDOs), a similar debt vehicle, played in the global financial crisis. Others actively are more familiar with the nature of CLOS, and are comforted by increased rules around them (see chart, page 40).
“Institutional investors understand the difference between CLOs and CDOs [a similar securitisation vehicle] backed by sub-prime mortgages,” according to Oliver Wriedt, co-chief executive officer at CIFC Asset Management. The US-headquartered private debt manager manages about $15.5 billion invested into CLOs, corporate credit and structured credit funds, about $3 billion of which is from Asia Pacific.
The credit rating agencies have spent years raising their scrutiny and expectations of securitisations, eager to avoid their embarrassing failure to spot the weaknesses in CDO structures ahead of the 2008 crisis. “Esoteric assets are not included and credit enhancement limits in recent CLOs are higher than those of pre-crisis CLOs. CLOs are also well diversified across industries in addition to having a wide range of concentration limits,” said Jian Hu, managing director for structured finance at Moody’s Investors Service.
He noted that credit enhancement now typically stands at 35% to 40% of ‘AAA’ rated structures in CLO 2.0, the new form of securitisation, versus 25% to 30% in the 1.0 version. In some cases there are higher minimums in first lien or senior secured loans too, although Hu said many limits remain the same as before. Plus he said Moody’s issues pre-sales reports for CLO issuances that highlight the credit strengths and challenges of these structures.
It has been working. Defaults are low, yet returns appealing. Moody’s said just 0.2% of CLO 2.0 assets were in default at the end of May, and yet mid-ranked CLO tranches can offer high single digit yields.
That combination is attracting institutional investors, particularly from China, where banks, asset management platforms and sovereign wealth funds have looked with interest at the assets.
“Demand is being driven by relative spread values and credit concern is, for now, not seen as a risk given the relatively benign interest rate environment and robust structure of the bonds,” added M&G Investments’ Patrick Janssen, a portfolio manager focused on asset backed securities.
The relatively low correlation of securitised products to other traditional assets such as bonds and equities also appeals to investors, said Sutee Mokkhavesa, executive vice president of risk and strategy at Muang Thai Life Assurance.
He told AsianInvestor that regional investors are likely to have allocated less than 2% of their fixed-income portfolios into CLOs.
Risks at hand
However, CLO investments offer risks, including illiquidity risk, market value risk and early payment or extension risk. In addition, rising demand has caused CLO yields to compress over the past 12 months.
“A few years ago, an ‘AAA’ tranche would pay about two percentage points above the Libor rate. Now, it’s [Libor plus] about 1.25 percentage points,” M&G Investments’ Janssen said.
The US dollar 3-month Libor rate was around 1.35% in mid-October, according to Federal Reserve data. In addition, many CLOs offer floating rate yields, which can benefit investors as the product yields will increase in a rising rate environment.
While yields drop, the type of borrower being included in the overall asset-backed securities markets is expanding. That could pose extra risk too, said Janssen.
“We have seen some new asset types in the US—fintech lending is one example. It will be interesting to see how this segment copes with economic stress. As interest rates rise, we will see how robust or otherwise the underwriting has been.” CIFC AM’s Wriedt believes that while liquidity in the CLO market is robust today, any reduction could cause increasing volatility in the mark-to-market value of the mezzanine tranches of CLOs, which are among the lower ranked debt portions.
On the collateral side, S&P has flagged signs of extreme risk-taking in the US leveraged loans market, while the level of investor demand for CLOs has allowed some issuers to weaken their deal covenants, or a set of limitations placed upon their financial behaviour to ensure their financial health.
“Although liquidity remains healthy, negative market signals have appeared, like the rising share of riskier ‘B’ rated loans, the near record-high leverage levels, or the continuing proliferation of borrower-friendly terms—over 70% of this year’s institutional issuance are covenant-lite,” it noted in an October 16 report. This leaves the US leveraged loan market looking more vulnerable to external shocks such as China’s rebalancing, the UK’s decision to leave the European Union, and the Federal Reserve’s interest-rate normalisation, the report said.
Yet despite this, the drive for yield is keeping CLOs popular. “Deal volumes and resets are likely to be strong for the rest of the year and continue well into 2018,” predicted Moody’s Hu.
As Asian investors’ pursue their amour with CLOs, they look set to ignore these alarm bells.