2020 M09 9
The term ‘structured credit’ encompasses a wide variety of securitised products, which offer fixed income investors opportunities across countries, underlying asset types and risk profiles.
Securitisation is the technique of converting a stream of anticipated future cash flows into one or more tradable securities, or bonds. The bulk of the market consists of bonds backed by pools of residential and commercial mortgages, consumer loans and corporate loans.
The securitisation process, discussed in more detail below, involves creating various ‘tranches’, which are bonds with ratings ranging from AAA (the safest tranche) through to unrated equity/residual cash flow (riskiest tranche).
The underlying assets in a CLO are a diverse pool of corporate loans, typically senior secured and sub-investment grade rated, spanning a wide range of industries. Although these are the same corporate loans our credit team analyses individually and daily, when packaging them together into a CLO the potential benefits they offer are quite distinct.
The exposure to the underlying loans is sliced into multiple tranches of varying seniority, creating a range of risk and return profiles for a portfolio manager to choose from.
The 'tranching' of the CLO liabilities creates a waterfall of risk. The most senior tranche (AAA rated) offers the lowest level of risk as it has a priority claim on the cash flow of the structure; this tranche would have a significant cushion in the event of the underlying pool of assets experiencing any stress (or defaults).1 Conversely, lower-rated mezzanine (BB and B rated) and unrated equity tranches are exposed to greater credit risk and investors owning these tranches are paid higher coupons to compensate, making them relatively high-yielding assets.
Thus, depending on the tranche selected, investors can use CLOs either as a defensive anchor (seeking to protect against downside risk) or for yield enhancement; their overall view of market conditions will determine their choice.
Securitised products are an important component of fixed income markets. In the US alone they account for over US$11 trillion of the entire US$43 trillion fixed income market. This compares to almost US$16 trillion of outstanding treasury bonds and around US$9 trillion of outstanding US corporate bonds.
Outstanding European securitised products currently total US$1.3 trillion, and other active markets exist in regions including Asia, Latin America and Australia.
The figure below shows the split of the US$4.3 trillion US and European securitised products outstanding, excluding US agency mortgage backed securities.2
Market components (US$ billions)
Source: US estimates from SIFMA as of Q1 2019, excluding $8.4 trillion of US agency mortgage-related securities. European estimates from AFME as of Q1 2019, converted to USD using quarter-end exchange rate, with the exception of the *European CLO outstanding number, which is a BofA Merrill Lynch Global Research estimate.
Source: Ninety One. For illustrative purposes only.
Part of the attraction of investing in CLOs is that the individual CLO bonds tend to trade at higher spread levels than corporate bonds with an equivalent rating, as shown in Figure 1. This differential, or premium, is largely explained by two factors: a liquidity premium and a complexity premium.
While these securities are tradeable and traded daily, they are arguably not quite as liquid as traditional corporate bonds, hence the liquidity premium. The need for a specialist skill set to analyse and price the securitisation structure – more complex than traditional corporate bonds – results in a complexity premium.
Figure 1. USD and Euro CLO and corporate bond spreads
Source: CLO spreads are primary spreads from JP Morgan as of 27 September 2019. Corporate bond spreads are asset swap spreads from rating based sub-indices of ER00, HE00, C0A0 and H0A0 from ICE Bond Indices as of 27 September 2019.
Although tranching within CLOs allows the creation of a range of risk profiles from a pool of loans, the performance of each tranche of a securitisation ultimately depends on the quality of the underlying portfolio. This makes active management of the portfolio vital, in our view.
Subject to a series of portfolio quality and concentration tests, a CLO manager selects the initial portfolio and then actively manages the positions based on thorough market and credit analysis. Among the most significant constraints on the manager are specific limitations on non-senior secured asset exposure (typically set at a 5-15% of the total loan portfolio) and on any CAA/CCC rated asset exposure (typically set at 7.5%).
Structural features of CLOs act to protect more senior tranches in times of credit deterioration. Most notably, interest payments on non-senior tranches (with ratings ranging from AA to B) are usually deferrable. Breaches of performance triggers can cause cash to be diverted away from mezzanine tranches towards paying the principal on senior tranches, a common occurrence in the global financial crisis. In most cases, the cumulative deferred interest on the non-senior tranches was repaid following the later recovery in loan market performance.
The specialist experience required in understanding these structural features, being able to distinguish between and price different CLO structures, as well as seeking to select the best underlying CLO managers, is critical to harnessing the structural premium available in CLO investing.
Whilst specialist experience is critical in evaluating any CLO investment, historically, CLOs backed by leveraged loans have performed very well from a loss perspective. They have suffered lower loss rates than equivalently rated senior unsecured corporate bonds, even during the global financial crisis of 2008, as shown in Figure 2.
Figure 2. 10-year loss rates (annualised) for CLO tranches vs. senior unsecured corporate bonds by rating (1993 – 2018)
Source: Moody’s Investors Service. CLO loss rates are estimated 10-year annualised loss rates by original rating for global CLOs, 1993-2018. Corporate bond loss rates are calculated from average 10-year annualised issuer-weighted global default rates (1983-2018) by rating, adjusted by average corporate debt recovery rates for senior unsecured bonds (1987-2018).
While CLO price movements have historically been closely correlated with price movements of other corporate credit-related instruments, factors specific to each market can cause them to diverge periodically. These factors can include elements such as differences in investor base and investment horizons, or even supply/demand imbalances within specific markets. As a result, the extent of the premium to be earned investing in CLOs compared to similarly rated corporate bonds can vary meaningfully over time.
This distinct CLO market 'micro climate' can mean that CLO tranches exhibit very different behavioural characteristics in different market conditions. And this can present compelling opportunities to an unconstrained credit investor with a deep understanding of these instruments. The ability to invest across the CLO capital structure (i.e. to choose from all the available tranches of a CLO) allows a portfolio manager to seek to take advantage of these relative-value opportunities wherever they arise.
In summary, we believe structured credit – and collateralised loan obligations in particular – is a useful and flexible addition to credit investors’ toolkit, offering the potential for an attractive yield pick-up while also displaying compelling behavioural characteristics. However, in our view, investment in this area requires dedicated and specialist expertise.
1 Each CLO tranche isn’t tied to any specific loans; rather the cash from the loan portfolio as a whole is allocated to the tranches, such that the senior tranches have first priority claims over cash received from the loans and are the last to suffer any potential losses.
2 Mortgage backed securities issued by US government-sponsored organisations such as Freddie Mae or Fannie MAC.
All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results.
Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss. Derivatives: The use of derivatives may increase overall risk by magnifying the effect of both gains and losses leading to large changes in value and potentially large financial loss. A counterparty to a derivative transaction may fail to meet its obligations which may also lead to a financial loss. Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates rise. Liquidity: There may be insufficient buyers or sellers of particular investments giving rise to delays in trading and being able to make settlements, and/or large fluctuations in value. This may lead to larger financial losses than might be anticipated. Loans: The specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Many loans are not actively traded, which may impair the ability of the Portfolio to realise full value in the event of the need to liquidate such assets.