Concerns over complexity and structural leverage late in the credit cycle have led many investors to overlook collateralized loan obligations (CLOs). However, late-cycle CLOs have historically benefitted from tight borrowing spreads and an opportunity to invest in higher-yielding assets. CLOs have demonstrated their resiliency as an investment class over several credit cycles, with low realized principal losses for CLO debt and robust returns for CLO equity. For long-term investors, CLOs can offer an attractive, front-end-loaded return profile that may complement longer-lockup alternative investments with back-end return profiles.
But investors need to understand the key structural features of these complex instruments, which provide limited liquidity, contain high levels of embedded leverage and lead to a wide range of return outcomes. As the volatility experienced by CLOs in the financial crisis showed, long-term investors should conduct a comprehensive assessment of credit risk, structural risk, manager capability and market risk, and have the ability to integrate these elements into a unified framework.
This paper discusses the basics of CLO equity, provides an approach for valuation, and highlights factors that can position CLO equity as a unique investment opportunity late in the credit cycle.
On the most basic level, CLOs are arbitrage vehicles. In a CLO, a special purpose vehicle issues long-term debt and equity tranches, the proceeds of which finance the purchase of a portfolio of floating-rate corporate bank loans. Equity tranche investors are positioned to benefit from term, non-recourse leverage without mark-to-market triggers. In other words, the CLO does not face liquidation or margin calls if the market value of the bank loan portfolio falls.
CLO equity returns are driven by the arbitrage between the cost of the debt tranches and the interest income generated by the portfolio of floating-rate bank loans. In Figure 1, the weighted-average cost of the debt tranches is roughly Libor + 173 basis points (bps). If the bank loan portfolio generates an average coupon of Libor + 350 bps, the arbitrage opportunity available for CLO equity investors is about 177 bps, before deducting ongoing deal expenses. This arbitrage is magnified by the embedded leverage in the CLO for the equity tranche.
The primary challenge faced by prospective CLO equity investors is determining a valuation framework. One approach is to think of the CLO equity return as a combination of two separate return streams: an interest only (IO) set of cash flows and a principal only (PO) set of cash flows. While the total CLO equity return is simply a combination of these two sets of cash flows, distinguishing the two streams allows us to differentiate the sources of return for the equity tranche and the risks associated with those returns. Figure 2 shows an example of cash flows to a CLO equity tranche as a function of time from initial investment.
The IO: a call option on bank loan spreads
The arbitrage between CLO debt and the underlying portfolio assets represents the IO component of the equity return. The starting point for evaluating a CLO equity investment is understanding what drives this arbitrage and assessing its yield potential and risks. For example, has the manager elected to add spread and risk through a larger exposure to CCC-rated bank loans, loans with weak covenant packages or higher exposure to more volatile industry segments? Does the portfolio have high exposure to higher-risk middle market issuers? Is the portfolio “barbelled,” with very high- and low-spread names, or is it uniform? All of these factors can affect the size and stability of both the IO and the PO cash flows, driving relative value up and down the capital structure and across deals.
Adding to the complexity, CLOs are dynamic, managed structures, with a reinvestment period generally spanning three to five years and with some limited reinvestment rights even after the end of the reinvestment period. Over the life cycle of a CLO, some portion of the loans will repay and some portion will default. Since both repayments of performing loans and recoveries from defaulted loans can be reinvested in new loans, equity investors are effectively long a call option on loan spreads.
The value of this option is driven by a number of factors, such as loan repayment rates, default rates, recovery rates and reinvestment spreads and prices. The repayment rate is important to equity investors because it affects the arbitrage in a CLO, as well as the underlying credit risk composition. Therefore, it is important to have an informed view of the turnover risk of the portfolio.
Repayment within a CLO deal occurs primarily due to underlying loan prepayment and the manager’s discretionary trading. Not surprisingly, companies tend to repay and refinance when bank loan spreads tighten, an option given the lack of call protection covenants in bank loans. The loan repayment rate can vary significantly depending on spread level, with the trailing 12-month repayment rate ranging from about 10% to 60% during the period from 30 September 2001 to 31 March 2017, according to S&P Leveraged Commentary & Data (see Figure 3). Even in spread environments that are sub optimal for refinancing, there will be some level of repayment because of changes of control, liability management or other factors, even default.
The reinvestment profile of the CLO portfolio is another critical determinant of the value of the IO. All else equal, widening bank loan spreads benefit equity holders. This is because wider spreads allow managers to redeploy repayment proceeds into higher-yielding assets, which would enhance the excess spread cash flow to the equity tranche because the cost of debt funding is fixed.
This is why some of the best CLO equity tranches were issued right before the financial crisis. The reinvestment option can act as a downside hedge for equity investors in a market-widening environment, as it allows managers to buy cheaper assets and improve excess spread. In volatile markets, CLO equity tranches often suffer secondary market price declines due to falling CLO portfolio values and expectations of higher default rates. However, the longer-term impact of higher equity cash flows due to reinvestment activity can more than offset initial price deterioration – especially if CLO managers are skilled enough to take advantage of volatile market conditions.
While spread widening can benefit the CLO equity arbitrage and therefore the value of the IO, the negative convexity resulting from limited call protection and repricing optionality common in the loan market can pose challenges in a benign or “grind-tighter” credit environment. In this case, expectations for long-lived IO cash flows can vanish when the CLO is called or when underlying loans reprice rapidly and are reinvested at significantly tighter spreads. However, these risks tend to be offset by the right of the majority of CLO equity class investors to refinance the CLO’s debt tranches. In combination with the implicit call on spreads baked in to the CLO structure, this refinancing option provides the CLO equity investor with asymmetric upside to bank loan spreads.
The PO: a call option on bank loan market values
In addition to the IO stream, the CLO equity holder has a claim on the market value of the bank loan portfolio, minus the par value of the CLO debt – the PO value. This residual, which is realizable when the CLO is called by equity investors or when it matures, is generally expressed as the equity net asset value (NAV). Expected default and recovery rates are both key drivers of equity NAV, as is trading activity by the CLO manager. To the extent the manager is able to invest in discounted bank loans that increase in value or mature at par, this gain will increase the equity NAV. However, there is also the possibility that the manager might add risk to the portfolio by buying assets that are trading at a discount due to credit issues. If the present value of the IO stream is insufficient to offset the riskiness of the PO, the equity investor may determine that it is smarter to exercise the call option sooner rather than later.
As CLOs exit the reinvestment period, the PO value becomes an increasingly important valuation, since a bigger proportion of future value depends on principal repayment of the underlying portfolio. At this stage in the CLO’s life cycle, analyzing the underlying portfolio by identifying default candidates becomes crucial to properly valuing the PO component.
Investing later in the credit cycle can be advantageous
Timing is critical for CLO investors, but not always in the way one might think. Logic would suggest that it is inopportune to invest in levered credit products late in the credit cycle. But the historical record of realized CLO performance suggests otherwise. Since the CLO structure benefits from two features – term liabilities and the reinvestment option – deals issued at the end of a credit cycle often benefit from tight borrowing spreads, which drive an increasingly attractive arbitrage as the credit cycle turns and the opportunity to invest in higher-spread assets presents itself. Figure 4 demonstrates this advantage: On a hold-to-maturity basis, deals issued in the two- to three-year period before the financial crisis realized the highest returns on average.
A word of caution
Although buy-and-hold CLO equity investors who invested prior to the crisis generally did well, today’s investors should bear two important considerations in mind:
During 2008–2009, valuations on CLO equity investments – of all vintages – were extremely volatile, in many cases dipping into the single digits. Investors forced to sell at the bottom of the market took heavy losses.
While CLOs are designed to withstand swings in bank loan prices (and may even benefit from volatility), CLO equity returns are sensitive to default rates. A rise in defaults can curtail distributions to CLO equity holders, as the deal is forced to divert these cash flows into new assets or to pay down debt. This occurred in 2009, when many CLOs skipped equity distributions for several quarters due to ratings downgrades and increased defaults. This risk underscores the importance of carefully assessing a manager's credit-picking skills; a deep, robust credit research platform is a must for CLO managers.
The CLO opportunity
Although CLOs are complex instruments, CLO equity can be boiled down into two key return drivers: a call on credit spreads and a call on the assets of the transaction. Each of these options needs to be valued within a unified risk framework that considers bottom-up credit factors as well as the top-down macroeconomic environment. While the mark-to-market risk of CLO equity is acute, hold-to-maturity investors can benefit from a robust and stable return profile. Unlike most alternative investments, CLO equity cash flows tend to be front-loaded, typically providing investors with current cash and reducing cost basis early in an investment life cycle.
For this reason, an opportunistic CLO strategy can serve as a complement alongside other longer-lockup investments. Many long lock-up investments, such as private equity or venture capital funds, generate back-end return profiles, so an allocation to CLO equity can smooth return profiles within broader alternatives buckets by providing front-end-loaded returns. A CLO-driven approach can also serve as an offset for higher-credit-beta investments, since it can potentially capitalize on a widening spread environment.
For longer-time-horizon investors willing to dig deeper into structural complexity, CLOs can potentially offer attractive return potential, even late in the credit cycle.