Asian institutional investors, and particularly insurers, have increasingly looked to securitised debt products such as collateralised loan obligations (CLOs) to offer additional yield amid low-rate conditions. But they may have to review their appetite for lower-rated tranches given the potential for a wave of downgrades and a lack of support by the US Federal Reserve’s new credit facility.
On April 20 Moody’s placed 976 debt tranches held by CLOs in Europe and the US on review for possible downgrade, affecting $23.3 billion-worth of debt, while a research note from Bank of America on April 15, noted that Moody’s and fellow rating agency S&P had downgraded between 17% and 19% of loans in global CLO portfolios, with most based in Europe and the US.
CLOs are issued by special purpose vehicles that use books of loans as collateral to support the debt products. The CLOs are typically structured into several tranches that receive varying ratings to reflect the risk of the underlying loans.
While debt tranches with high credit ratings ranging from triple- A to single-A were largely excluded from Moody's rating review, those with lower-tier investment grade ratings look more vulnerable, particularly in the US. Moody’s placed over half of the 667 CLO tranches in the US that it rated at Baa1 or below on review.
“We have already started to see the beginning of the downgrades on loans but are yet to see the real impact of the lockdowns on default levels. But it is our expectation that this will tick up in Europe just as it will in the US,” Andrew Lennox, a London-based asset-backed securities portfolio manager at US fund firm Federated Hermes, told AsianInvestor.
This could offer some pause to investors who had been interested in investing into the investment grade tranches of CLOs.
Now is not the best juncture for those unfamiliar with these instruments to take the plunge, suggested one London-based senior investment executive at a British life insurer. “We don’t invest in CLOs and certainly would not start doing so in the near future,” he told AsianInvestor on condition of anonymity.
“Currently, with defaults likely, CLO investing is not about the structuring or a credit cycle view but rather a view on idiosyncratic risks and individual companies. So I don’t think the timing is right for anyone starting in this space.”
Indeed, many financial regulators in Asia encourage life insurers to stay away from BBB bond investments, over fears the instruments could descend into junk bond status. In addition, new or incoming risk-based capital rules typically slap high capital charges on high yield bonds, which might also deter investors from holding CLO tranches that could be downgraded.
The news isn't dissuading all particpants. A Bangkok-based insurance executive had told AsianInvestor on March 13 that offshore investment-grade-only CLOs looked interesting because they offered attractive spreads. The spreads of CLO triple-A and triple-B tranches were around 225 basis points and 800 basis points on average respectively at the end of March, according to figures from several asset managers.
When asked by AsianInvestor whether Moody's decisions had changed his mind at all, the insurance executive said he remained interested.
Kevin Jeffrey, director of investments for Asia at consultancy Willis Towers Watson, said the strength of investor demand for high-quality CLOs had mostly been because they were seen as safe haven assets and they have experienced relatively subdued repricing. Lower-quality ones, on the other hand, did "notably reprice", after being seen as quite attractive at one point.
Insurance and pension funds in Asia Pacific have generally held between zero and a mid-single digit percentage of their total investment portfolios in CLOs, with insurers generally more likely to invest in the vehicles, said Jeffrey.
"We would also note that there has been an increased interest in many types of alternative credit given the impact we have seen across a wide range of fixed income markets, not just CLOs," he added.
The struggle of CLOs reflects a damaging combination of rapid market growth, loosening standards and a massive financial jolt.
Over the past 10 years the US leveraged loan market has more than doubled in size to $1.2 trillion, according to a Reuters report, and during this low-rate period it was often a seller’s market. Many of the loans issued during this time were covenant-lite, meaning they placed relatively few financial constraints onto the borrower.
The onset of the coronavirus pandemic has caused huge numbers of individuals and companies to begin delaying or defaulting on loan payments. It has also tested the built-in diversification of CLOs, because it has adversely affected almost all sectors of country economies.
“CLOs rely on diversity to try to mitigate some of the underlying portfolio risks. I think what's happening right now due to Covid-19 is that this diversity doesn't play out well in a scenario where most end markets are being impacted at the same time,” said Rahul Kotwal, Hong Kong-based founder and managing partner at private debt manager Zerobridge.
In particular, restaurants, leisure sectors are more vulnerable, said Stephane Michel, a senior portfolio manager at Federated Hermes.
“You would assume healthcare would be an easy sector to back when you are having a healthcare crisis, but here you have to choose your names carefully as some companies have been in the wrong part of healthcare provision,” he told AsianInvestor.
Aspiring CLO investors will also need to consider the fact that the instruments are not receiving heavy support from central banks.
In the US, the Federal Reserve has extended its purchasing programme to include CLO vehicles as part of its emergency measures to ensure ongoing liquidity in the US financial system. However, it said it would only buy triple-A bonds of CLOs that hold newly-originated leveraged loans, limiting the scope of loans covered and potentially the efficacy of the stimulus on these vehicles.
In Europe, the European Central Bank did not include CLOs in its €750 billion ($813.5 billion) bond-buying programme.
Lennox noted that “the ECB has been quite firm in the past about not including CLOs”, but added that the financial dislocation in the European market may also be smaller in the US.
This analysis squares with Moody’s approach; the rating agency place a lower proportion of the debt slices held by European CLOs on review for downgrade than those of US vehicles.
However, Federated Hermes’ Michel said this isn’t necessarily a bad thing, noting that CLO investors would not want to have a large buyer such as a central bank “taking the market away” from investors and managers.
“If [the credit facility] continues for too long, then obviously investors start to get squeezed out, spreads start to move in a direction which may not reflect the credit risks but instead reflects a dominant investor buying the market. That's a situation we don't want to end up in,” he added.
Joe Marsh contributed to this article.