Why private debt-backed CLOs merit extra caution

Collateralised loan obligations (CLO) haven't got the best of reputations due to their role in the global financial crisis, but they've been making a comeback for several years now and in Asia are becoming increasingly popular with yield-starved asset owners.

They're also not considered as risky as they once were.

Even so, buyers should beware of the managers they bestow their trust with, especially if there's private direct lending in the underlying portfolio, investment experts say.

CLOs are financial vehicles that contain packages of loans, including leveraged loans, slotted into different levels of risk. The vehicles then issue bonds using these debts as collateral with different credit ratings and yields.

A major source of debt for CLOs is the US leveraged loan market, which S&P Global Intelligence last month said had reached a record $1.2 trillion.

Richard Tan, portfolio specialist for Asia of Mercer, told AsianInvestor that, although asset owners typically allocate less than 5% to CLOs, it “appears to be trending upwards.”

Although regarded as relatively sophisticated investment instruments, CLOs could yet be made “more digestible” over time, he added.

Deemed attractive for their income-yielding potential, CLOs are also seen being a potential portfolio diversifier from traditional fixed-income instruments. 

“In Asia, generally institutional investors with scale, such as insurance companies, purchase tranches in a CLO with the intention of seeking low(er) risk and steady cash flow,” Tan said.

In particular, Chinese institutional investors are showing a growing appetite for CLOs, including China Taiping Insurance's subsidiary Taiping Investment Holdings.

There are potential traps where private direct lending is involved, though, due to a relative lack of transparency.

“As you move to the securitisation of smaller loans that are often private direct lending, [the] available information is reduced,” said Matthew Natcharian, head of structured credit for Barings. “They are not publicly rated but they will have private shadow ratings from the rating agencies, where they are submitted for a credit estimate. But that estimate is not a public rating and that's not available to others.”

In addition, private direct lending CLOs don’t trade often in the secondary market so there isn’t regular pricing.

“[The managers] can actively manage them but direct lending CLOs are a little harder to trade actively because there isn't much liquidity in that market,” Natcharian told AsianInvestor.

OTHER RISKS

Lack of transparency aside, CLOs backed by private direct lending can add extra risk to investor portfolios in another respect: because many of these loans are often covenant-lite.

“In corporate direct lending, it’s a borrower's market where loan quality is not the same as it used to be,” said Shawn Khazzam head of the alternatives solutions group for the Asia-Pacific region at JP Morgan Asset Management.

And loan covenants are crucial as they serve as an "early warning system and an opportunity" for investors to fix a bug before a borrower defaults, he said.

There is another side to the coin though, which is that private lending can be better secured and more stable because they don’t fluctuate with daily pricing. Plus, investors get some extra returns to compensate for the additional risks, Natcharian said.

“Because of that lack of transparency, the similarly rated tranches of those types of CLOs trade at a wider spread, so you do get compensated for that lack of liquidity,” he said.

As to whether CLOs with a higher proportion of private direct lending offer more perils to investors, Tan said, “jury is still out regarding this.”

“Some proponents argue that a CLO isn't that risky. For example, Guggenheim investments conducted a study which found that from 1994 to 2013, CLOs experienced significantly lower default rates than corporate bonds,” he said.

But that could conceivably change.

As Tan noted, with a low interest rate environment expected to persist for the foreseeable future “some investors [may be motivated] to take-on additional risks in search of higher returns.”

While CLOs are not the only option, he said that other private market strategies, where CLOs reside, could “potentially offer more conducive fundamentals for investment consideration.”

MANAGER RELIANCE

CLOs carrying private direct lending require deft handling by their managers to unlock their potential.

They also need “strong sourcing networks to find the right opportunities where they can get covenant-tight rather than covenant-lite,” Khazzam said.

But since they are less able to independently verify information, there is a greater element of trust required.

So it is very important for asset owners to conduct all the necessary due diligence on any prospective CLO managers before committing funds,” Natcharian and Khazzam agreed.

“As an investor you have to judge, are you picking up enough spread for that extra risk and are you confident in the manager that you have selected that they will do a good job managing the credit risks,” Natcharian said.

As Kevin Jeffrey, a senior portfolio specialist of Willis Towers Watson, advises investors: “lending as broadly as possible, and using appropriate skilled managers to invest, is in our view the best way to avoid unjustified risks in portfolios.”