Our Multi-Asset Credit strategy aims to generate attractive long-term total returns by investing dynamically across global credit markets.
To target a smoother investment journey and competitive risk-adjusted performance, the team actively allocates across a broad credit opportunity set.
A key feature of our approach is our ability to use the broad opportunity set and seek to dynamically allocate the portfolio to the more attractive elements of the credit market at the right time.
The fast view
- The term ‘structured credit’ encompasses a wide variety of securitisation markets (markets that pool underlying assets into tradable securities).
- This paper focuses on collateralised loan obligations (CLOs) as this part of the structured credit market is most relevant for our Multi-Asset Credit strategy.
- Compared with traditional corporate credit investments, CLOs offer various benefits, including historically lower loss rates for comparable credit ratings than corporate bonds across most rating categories.
- CLOs also represent a potential source of additional yield for investors with a deep understanding of the asset class, thanks to their ‘liquidity premium’ and ‘complexity premium’.
- We believe the distinct and dynamic behaviour of CLOs present significant relative-value opportunities to active and experienced credit investors.
What is structured credit?
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 tranches (the riskiest tranches).
CLOs: a key part of a credit investor’s toolkit
The underlying assets in a CLO are corporate loans — typically a diverse pool of senior secured and sub-investment grade rated loans, spanning a wide range of industries. The assets are actively managed by a CLO manager. Although these are the same corporate loans our credit team analyses individually and daily, when these are packaged together into a CLO they offer quite distinct potential benefits to portfolios.
Multiple tranches of varying seniority are issued from each CLO, creating a range of risk and return profiles for a portfolio manager to choose from.
A flexible tool
The ‘tranching’ of the CLO liabilities creates a waterfall of risk levels for investors to choose from. 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 higher credit risk; investors owning these tranches are paid higher coupons to compensate, making them relatively high-yielding assets.
Thus, depending on the tranche selected, portfolio managers 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.
Sizing up the market
Securitised products are an important component of fixed income markets. In the US alone they account for over US$13 trillion of the entire US$55 trillion2 fixed income market (24%). This compares to almost US$24 trillion of outstanding treasury bonds and around US$10 trillion of outstanding US corporate bonds.
Outstanding European securitised products currently total US$1.2 trillion3, and other active markets exist in regions including Asia, Latin America and Australia.
Figure 1 shows the split of the US$4.4 trillion US and European securitised products outstanding, excluding US agency mortgage backed securities4.
Figure 1: Market components (US$ billions)
Source: US estimates from BofA Global Research as at Q3 2023, excluding US$10.8 trillion of US agency mortgage-related securities. European estimates from AFME as at Q3 2023, converted to USD using quarter-end exchange rates.
How a CLO works
Source: Ninety One. For illustrative purposes only.
Offering relatively high spreads
Part of the attraction of investing in CLOs is that individual CLO bonds tend to trade at higher spread levels than corporate bonds with an equivalent rating, as shown in Figure 2. 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 2: USD and Euro CLO and corporate bond spreads, basis points
Source: CLO spreads are from Citi Velocity as at 29 February 2024. Corporate bond spreads are asset swap spreads from rating based sub-indices of ER00, HE00, C0A0 and H0A0 from ICE Bond Indices as at 29 February 2024.
Requiring deep expertise
Understanding the structural nuances of each deal is key to valuing individual CLO tranches. Importantly, each deal includes a set of performance triggers, which if breached, can cause interest payments on junior tranches to be diverted to repaying the principal on more senior tranches. Junior tranche interest deferral was a common occurrence in the Global Financial Crisis (GFC), helping protect senior tranche investors through a period of loan market stress. In most cases, the cumulative deferred interest on the non-senior tranches was repaid following the later recovery in loan market performance.
Detailed due diligence on the CLO manager and the deal-specific constraints within which they operate is another key part of the investment process for a CLO investor. Successful CLO managers can add value for investors by actively managing the underlying loan portfolio and minimising credit losses. Each CLO contains a list of portfolio concentration and quality limits, according to which managers must construct and trade the underlying portfolios.
Specialist experience and understanding of these structural features are critical in harnessing the complexity premium available in CLOs investing. Investment managers must be able to distinguish between different CLO structures, as well as a wide range of CLO manager styles and track records to ensure that they are being compensated adequately for the underlying risks.
What about the risks?
While 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 comparable or lower loss rates than equivalently rated senior unsecured corporate bonds, even including the GFC of 2008, as shown in Figure 3.
Figure 3: 10-year loss rates (annualised) for CLO tranches vs. senior unsecured corporate bonds by rating (1993 – 2019)
Source: ICE BofA Merrill Lynch, Moody’s as at 31 December 2023. Using 10yr cumulative loss rates for global CLOs (1993 – 2021 and annualising). For corporates, we annualise 10yr default rates (1983-2019) and apply the long-term average (1987-2019) recovery rate for senior unsecured bonds of 47%.
The distinct behaviour of CLOs creates opportunities
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 by investing in CLOs compared to similarly rated corporate bonds can vary meaningfully over time.
The distinct characteristics of the CLO market can mean that CLO tranches exhibit very different behaviour in a variety of market conditions. 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 any relative-value opportunities that arise.
In summary, we believe structured credit – and the CLO market in particular – is a useful and flexible addition to a credit investor’s toolkit, offering the potential for an attractive yield pick-up while also displaying attractive behavioural characteristics. However, in our view, investment in this area requires dedicated and specialist expertise.
1 Each CLO tranche is not tied to any specific loans; instead, 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 all of the underlying loans in the CLO and are the last to suffer any potential losses.
2 Source: SIFMA, as at end 2022.
3 Source: AFME, as at Q3 2023.
4 Mortgage-backed securities issued by US government-sponsored organisations such as Freddie Mac or Fannie Mae.
General risks. 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. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.
Specific risks. 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.
