Senior loans and CLOs: Asset classes amid rising rates?
Amid positive market fundamentals, an enhanced regulatory framework and the prospect of higher interest rates in Europe and the US senior secured loans and collateralised loan obligations (CLO) are emerging as viable alternative investment opportunities, according to AXA Investment Managers (AXA IM).
The prolonged backdrop of low yields has spurred investors to seek greater diversification via non-traditional credit asset classes, which aim to provide potentially attractive premiums relative to traditional instruments, says the asset manager.
AXA IM’s Head of Structured Finance, Deborah Shire, explains: “Institutional investors globally have started to venture further along the credit continuum, evaluating the risk and return trade-offs of investing in more complex higher-yielding assets, such as capital solution transactions, senior secured loans and CLOs.”
Senior secured loans are credit instruments typically suitable for corporations looking to fund acquisitions, refinance existing debt and support other business operations, including expansion. They have first priority in receiving payments when a borrower is servicing its debts.
CLOs, on the other hand, invest in a pool of broadly syndicated senior secured loans, covering a wide range of issuers and industries. The portfolio of loans – of varying seniority, ranging from AAA to B – is selected and managed by a collateral manager, who actively buys and sells loans based on their attractiveness.
Both asset classes have enjoyed substantial growth since the global financial crisis, supported by corporate sector health, benign default rates and generally robust macroeconomic momentum. A key benefit of these asset classes is that unlike high-yield bonds, they often bear floating-rate coupons, which serve as a favourable hedge against potentially higher US interest rates.
“The senior secured loan sector is deep, with a global market size of more than €1.2 trillion (US$1.35 trillion)1. There is a diversity of issuers in terms of geography and sector that allows for potentially superior portfolio construction and disciplined selection,” says Shire.
Senior loans have historically provided steady returns. According to the S&P/LSTA Leveraged Loan Index2, the market has continued to recover since 2008, with average annual returns of more than 5%, while the mean default rate since the benchmark’s inception in 1998 is 3.2%3. In addition, Moody’s data shows that in October 2015, the high-yield bond default rate was approximately 4%, while the leveraged loan default rate was less than 2%.
Turning to CLOs, Shire says the sector has improved in both risk profile and depth, supported by market reforms. Regulations in Europe and the US now require CLO managers to hold a substantial stake in each issue. This “risk-retention” rule ensures that CLO managers have ‘skin in the game’, which enhances the alignment of investors’ interest with their own, says Shire.
Projections for 2017 issuance range from as much as US$75 billion to as little as US$40 billion, according to Bloomberg data4. The market reached a new high of US$124 billion in 2014, but in 2016 CLOs issuance totalled US$71.9 billion, down from US$98.85 billion in 2015.
The decline since 2014 is in part due to the US risk-retention rule, which was officially introduced in December 2016, and regulations that constrain banks’ ability to originate loans to highly leveraged companies.
But these new rules have helped contribute to CLOs’ attractiveness as an investment class. While overall net supply has dropped, net demand has continued to grow, leading to higher loan prices and tightening credit spreads.
The market has also deepened with the growth of a secondary market and a more diversified, longer-term investor base, says Shire: “The secondary market, which was virtually non-existent pre-2008, is now trading at a size that narrows the bid-ask spread, under normal market conditions, to levels closer to those for corporate bonds with similar ratings.”
Citing Citi research5, she adds: “Pension funds, insurance companies and asset managers now make up more than half of the investor base for mezzanine tranches, compared to less than 10% before 2008.”
With strong structural protections in place, as well as historically low default rates, AXA IM, which had US$799 billion of assets under management as at 31 March 2017, believes CLOs currently offer attractive spreads compared to other traditional debt products.
AXA IM June 2017
Sources:
1 Leveraged Commentary & Data Comps as at March 2017
2 S&P/LSTA US Leveraged Loan 100 Index as at June 2017
3 LSTA as at June 2017
4 Bloomberg as at December 2016
5 Citi research as of December 2016
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