Highland points to CLO market dislocation
Collateralised loan obligations backed by senior secured US corporate loans are about the only corner of the structured credit market to remain orphaned from investors, says Highland Capital.
While residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS) and credit-card asset-backed securities (ABS) have all found buyers post financial crisis, CLOs still lack a home, notes Mark Okada, the firm’s co-founder and CIO.
The Dallas-based alternative credit firm is the largest CLO manager by AUM in the US with $14 billion, according to a June review by Standard & Poor’s. That makes up the majority of its total $20 billion in assets.
Since 2008 Highland has branched out to investing in the equity and debt tranches of CLOs, picking up these securitised assets after the market collapsed in 2008.
Today, investors in CLOs are mostly opportunistic buyers, including hedge funds and proprietary desks of banks.
Okada says a CLO tranche rated A could yield a 10% return in secondary-market trading, compared with the 2% to 2.5% coupon you get from investing in an A-rated CLO at issuance.
Such returns are possible if a CLO is redeemed by the manager at par as secondary market prices fall, meaning investors benefit from both capital gains and coupon.
Such dislocation is also seen in the trading levels of A-rated CLOs, which are trading at an average of 77.5 cents on the dollar, or a spread of 550bp above Libor. That compares with a spread of 200bp for an average A-rated corporate bond, says Highland, citing bank data.
In spite of the tainted reputation of collateralised debt obligations (CDOs) backed by sub-prime mortgages, and credit rating agencies being lambasted for model failures that saw them subsequently downgrade many issuances to junk from AAA when they were first issued, Okada defends CLO ratings as stable pre- and post-crisis.
“This is a specific analysis of one part of the structured credit world where the rating actually worked,” he says. “On average, CLOs are rated AAA- or AA+, they have not had a whole rating migration through the crisis [contrary to subprime CDOs].”
Some market participants use the term CDOs broadly, seeing CLOs as a subset of CDOs.
Further, Okada says institutional investors can draw comfort from the fact that CLO performance is driven by fundamentals of the underlying collateral – unlike MBS.
Highland’s CLO portfolio comprises senior secured bank loans that would see the holders of a CLO debt tranche able to claim cashflows ahead of others, if the underlying businesses default on their loans.
“Rather than focusing on mark-to-market returns, and making assumptions over what the mortgage pool would do over time [as affected by] prepayment risks…or guessing the extent of impact from another round of quantitative easing by the US Federal Reserve, for CLOs we are less worried as we have confidence about the underlying assets,” notes Okada.
He argues that fundamental risks such as corporate default faced by CLO holders are low. He says the US leveraged loan default rate hovers around 1%, compared with 5% in Europe.
Instead, Okada thinks the major concern for CLO investors is liquidity risk, citing uncertainty over whether the eurozone economy will face a long, drawn-out deflationary/stagnant growth environment such as Japan endured in the 1990s.
New CLO issuance seems to have rebounded gradually in the US since a low in 2009. Year-to-date, $20.7 billion has been issued, surpassing the $12.7 billion for the whole of 2011. Estimates for this year point to $30 billion in issuance, according to Wells Fargo research.
Secondary market trading volume in CLOs year-to-date stands at $10.4 billion, compared with $22.5 billion for the whole of last year.
But while Highland sees plenty of opportunities for investors in the CLO market in the US, Okada says that Europe, by contrast, provides very few.
In fact, in February the firm sold its European CLO business with $3 billion in AUM to Carlyle. Prior to that it had been advising clients to scale out of their European holdings due to what it deemed unattractive relative risk-adjusted returns compared with the US CLO market.