By Christopher Whittall
Investors hungry for returns are piling back into securities
once tarnished by the financial crisis.
Complex structured investments developed a bad reputation during
the credit crunch. Ten years later, investors seeking yield are
overcoming their skepticism and buying into securities that rely on
financial engineering to juice returns.
Volumes of CLOs, or collateralized loan obligations, hit a
record $247 billion in the first nine months of the year, according
to data from J.P. Morgan Chase & Co. Fueled by a wave of
refinancings and nearly $100 billion in new deals, that far
outpaces their recent full-year high of $151 billion in 2014 and
the precrisis peak of $136 billion in 2006.
The CLO boom is the latest sign of the ferocious hunt for yield
permeating markets. Stellar performance over the past year has made
CLOs increasingly hard to ignore for investors like insurance
companies and pension funds.
CLOs carve up a portfolio of bank loans to highly indebted
companies into slices of securities with different levels of risk.
The securities at the bottom of the CLO stack offer the highest
potential source of returns, but they are also the first to absorb
losses if there are defaults in the underlying loan portfolio. The
more senior slices offer lower returns but are more insulated from
losses.
CLOs are often lumped together with other alphabet-soup acronyms
of the financial crisis, such as more toxic CDOs, or collateralized
debt obligations. But CLOs actually weathered the financial crisis
well: Investors who bought at the top of the market in 2007
suffered paper losses, but there were no defaults at all for the
highest-rated securities.
That track record has helped boost CLOs' appeal for investors
with lingering concerns over scooping up more complex
investments.
"The demand for things like CLOs....is extraordinary," said Rick
Rieder, chief investment officer for global fixed income at
BlackRock Inc.
CLOs are one of the largest demand sources for the leveraged
loan market, which has also been booming this year. Volumes of
leveraged loans, often used by private-equity firms to fund
buyouts, are on track to surpass their 2007 record, according to
LCD, a unit of S&P Global Market Intelligence. At the same
time, investors have voiced concerns about companies' rising
leverage level, and weaker creditor protections.
Within a CLO are different risk profiles: Investors in the most
senior, AAA-rated piece of debt get paid first and are the most
insulated from losses if defaults rise in the underlying loan
portfolio. They also receive the skinniest returns. Slices of debt
further down receive higher returns, but will suffer losses if
defaults spike. At the bottom sits the equity tranche, the first
loss-absorber and last to get paid, but the highest potential
source of returns.
A 2014 report from Standard & Poor's Ratings Services stated
that AAA-rated and AA-rated CLO tranches incurred no losses at all
between 1994 and 2013. Loss rates for lower-rated tranches,
meanwhile, were low -- just 1.1% for B-rated securities over that
period.
That doesn't prevent some conservative investors from conflating
the CLOs with the now-infamous CDOs, many of which were linked to
subprime mortgages and spread and amplified losses in the U.S.
housing market. One breed of CDOs are on a comeback path of their
own, with more investors returning to them during an aging bull
market.
Many people were "burnt by these acronyms from the crisis," said
Zak Summerscale, head of credit fund management for Europe and Asia
Pacific at Intermediate Capital Group. He is currently recommending
that clients buy senior CLO tranches over investment-grade
bonds.
CLOs, like other types of securitizations, have been subject to
greater regulation since the financial crisis. That includes
forcing funds that manage a CLO to retain 5% of the securities, in
an effort to align incentives with investors.
That has "attracted additional capital into the market," said
Mike Rosenberg, a principal at alternative investment manager
Tetragon.
Assets under management in the "loan participation" sector -- a
proxy for funds that invest in CLOs -- have grown 21% this year to
$206 billion, according to Thomson Reuters Lipper.
The pickup in CLOs has been a boon to banks weathering declines
in trading revenues in the current low-volatility environment.
Revenue from CLO-related activity at the top 12 global investment
banks more than doubled over the first half of 2017 from a year
earlier to almost $1 billion, according to financial consultancy
Coalition.
CLO investors have been handsomely rewarded in recent months.
J.P. Morgan strategist Rishad Ahluwalia recommended clients buy
CLOs last July as he thought they looked too cheap. Between then
and the end of September, BB-rated CLO tranches returned 25.4%,
compared with a 25.2% return for the technology-oriented Nasdaq
stock index, according to his calculations.
"CLOs have been an absolute home run," said Mr. Ahluwalia,
though he added such chunky returns aren't repeatable.
Analysts say CLOs got beaten down last year following a series
of troubles in the underlying loan market, including distress in
the energy sector. Some analysts think the strong rally in CLO
tranches since then should give investors pause; others think the
market has further to run.
Renaud Champion, head of credit strategies at Paris-based hedge
fund La Française Investment Solutions, likes AAA-rated CLO
tranches but with a twist: leverage.
Mr. Champion says he buys senior European CLO tranches and
borrows money against them to increase the size of his position
between five and 10 times. That can amplify gains -- and losses --
significantly.
"The difference between now and a year ago is the availability
of leverage," he said.
Bankers say only a small proportion of CLO buyers use leverage
and emphasize that trades are subject to daily margin calls. That
means investors have to post cash to cover mark-to-market losses on
a position, which in turn limits how much they are willing to
borrow.
"The leverage in the system today is a fraction compared to
precrisis," said J.P. Morgan's Mr. Ahluwalia.
Write to Christopher Whittall at
christopher.whittall@wsj.com
(END) Dow Jones Newswires
October 22, 2017 18:31 ET (22:31 GMT)
Copyright (c) 2017 Dow Jones & Company, Inc.
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