By Michael Aneiro
Mention any investment that starts with the word “collateralized” and ends with the word “obligation” and an average investor will likely respond with glazed eyes or financial-crisis flashbacks. Yet, lately, savvy investors seeking decent yields and strong credit ratings are increasingly turning to structured investments known as collateralized loan obligations, or CLOs.
A few years ago, collateralized debt obligations, or CDOs, were among an alphabet soup of complex investments — backed by terrible mortgage loans but stamped with stellar credit ratings — that became shorthand for underestimated, catastrophic risk, after they defaulted in droves and took down entire financial institutions.
Instead of mortgage debt, CLOs invest in bank loans made to junk-rated companies, but the structure is the same: Pool the loans, divvy up the pool and parcel out slices to investors based on the sort of risk, and yield, they seek.
CDOs went belly-up in the financial crisis because so many underlying mortgage loans turned out to be worthless. CLOs suffered mark-to-market losses when they (and everything else) became hard to sell, in what essentially amounted to a bank run, and the market dried up. But by and large, their underlying loans performed just fine.
THE MARKET RECOVERED and is booming again, with CLO issuance powering an insatiable demand for bank loans. April saw $12.3 billion of new CLO issuance, according to Standard & Poor’s LCD, the most in any single month since November 2006. This year is on pace to produce $106 billion in new CLO supply, according to Barclays, 8% more than the record amount seen in 2007, at the peak of the last credit boom.
Several bond-fund managers tell Barron’s that they’re increasingly turning to collateralized loan obligations as yields on junk-rated bonds and loans look less appealing. They say the quality of loan underwriting and CLO issuance is better than it was during the last cycle, while CLOs can offer higher yields than comparably rated corporate debt. Barclays says triple-A rated CLOs currently offer 11 times more spread, or yield premium over risk-free benchmarks, than triple-A rated corporate bonds.
Mark Okada is chief investment officer at Highland Capital, which oversees $13 billion in CLO assets. He says the renewed interest in collateralized loan obligations makes sense. “Asset spreads in high yield will widen in a crisis, then revert to the norm, and then overshoot, and certainly high yield is getting close to that now,” he says. “CLOs are the next natural progression as markets look to securitization as a way to parse risk. At this part of the cycle, I have to ask myself if I really want a bank loan at 4%, but if you can give me a BBB [-rated] CLO tranche at 5% or 6%, that’s really interesting.”
According to S&P, CLO tranches rated BBB — the bottom tier of investment grade — have defaulted about a quarter as often as corporate bonds with the same rating…
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