Hunt for Yield Fuels Boom in Another Complex, Risky Security -- Update

By Christopher Whittall Features Dow Jones Newswires

Investors hungry for returns are piling back into securities once tarnished by the financial crisis.

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Complex structured investments developed a bad reputation during the credit crunch. Ten years later, investors seeking yield are overcoming their skepticism and buying into securities that rely on financial engineering to juice returns.

Volumes of CLOs, or collateralized loan obligations, hit a record $247 billion in the first nine months of the year, according to data from J.P. Morgan Chase & Co. Fueled by a wave of refinancings and nearly $100 billion in new deals, that far outpaces their recent full-year high of $151 billion in 2014 and the precrisis peak of $136 billion in 2006.

The CLO boom is the latest sign of the ferocious hunt for yield permeating markets. Stellar performance over the past year has made CLOs increasingly hard to ignore for investors like insurance companies and pension funds.

CLOs carve up a portfolio of bank loans to highly indebted companies into slices of securities with different levels of risk. The securities at the bottom of the CLO stack offer the highest potential source of returns, but they are also the first to absorb losses if there are defaults in the underlying loan portfolio. The more senior slices offer lower returns but are more insulated from losses.

CLOs are often lumped together with other alphabet-soup acronyms of the financial crisis, such as more toxic CDOs, or collateralized debt obligations. But CLOs actually weathered the financial crisis well: Investors who bought at the top of the market in 2007 suffered paper losses, but there were no defaults at all for the highest-rated securities.

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That track record has helped boost CLOs' appeal for investors with lingering concerns over scooping up more complex investments.

"The demand for things like CLOs....is extraordinary," said Rick Rieder, chief investment officer for global fixed income at BlackRock Inc.

CLOs are one of the largest demand sources for the leveraged loan market, which has also been booming this year. Volumes of leveraged loans, often used by private-equity firms to fund buyouts, are on track to surpass their 2007 record, according to LCD, a unit of S&P Global Market Intelligence. At the same time, investors have voiced concerns about companies' rising leverage level, and weaker creditor protections.

Within a CLO are different risk profiles: Investors in the most senior, AAA-rated piece of debt get paid first and are the most insulated from losses if defaults rise in the underlying loan portfolio. They also receive the skinniest returns. Slices of debt further down receive higher returns, but will suffer losses if defaults spike. At the bottom sits the equity tranche, the first loss-absorber and last to get paid, but the highest potential source of returns.

A 2014 report from Standard & Poor's Ratings Services stated that AAA-rated and AA-rated CLO tranches incurred no losses at all between 1994 and 2013. Loss rates for lower-rated tranches, meanwhile, were low -- just 1.1% for B-rated securities over that period.

That doesn't prevent some conservative investors from conflating the CLOs with the now-infamous CDOs, many of which were linked to subprime mortgages and spread and amplified losses in the U.S. housing market. One breed of CDOs are on a comeback path of their own, with more investors returning to them during an aging bull market.

Many people were "burnt by these acronyms from the crisis," said Zak Summerscale, head of credit fund management for Europe and Asia Pacific at Intermediate Capital Group. He is currently recommending that clients buy senior CLO tranches over investment-grade bonds.

CLOs, like other types of securitizations, have been subject to greater regulation since the financial crisis. That includes forcing funds that manage a CLO to retain 5% of the securities, in an effort to align incentives with investors.

That has "attracted additional capital into the market," said Mike Rosenberg, a principal at alternative investment manager Tetragon.

Assets under management in the "loan participation" sector -- a proxy for funds that invest in CLOs -- have grown 21% this year to $206 billion, according to Thomson Reuters Lipper.

The pickup in CLOs has been a boon to banks weathering declines in trading revenues in the current low-volatility environment. Revenue from CLO-related activity at the top 12 global investment banks more than doubled over the first half of 2017 from a year earlier to almost $1 billion, according to financial consultancy Coalition.

CLO investors have been handsomely rewarded in recent months. J.P. Morgan strategist Rishad Ahluwalia recommended clients buy CLOs last July as he thought they looked too cheap. Between then and the end of September, BB-rated CLO tranches returned 25.4%, compared with a 25.2% return for the technology-oriented Nasdaq stock index, according to his calculations.

"CLOs have been an absolute home run," said Mr. Ahluwalia, though he added such chunky returns aren't repeatable.

Analysts say CLOs got beaten down last year following a series of troubles in the underlying loan market, including distress in the energy sector. Some analysts think the strong rally in CLO tranches since then should give investors pause; others think the market has further to run.

Renaud Champion, head of credit strategies at Paris-based hedge fund La Française Investment Solutions, likes AAA-rated CLO tranches but with a twist: leverage.

Mr. Champion says he buys senior European CLO tranches and borrows money against them to increase the size of his position between five and 10 times. That can amplify gains -- and losses -- significantly.

"The difference between now and a year ago is the availability of leverage," he said.

Bankers say only a small proportion of CLO buyers use leverage and emphasize that trades are subject to daily margin calls. That means investors have to post cash to cover mark-to-market losses on a position, which in turn limits how much they are willing to borrow.

"The leverage in the system today is a fraction compared to precrisis," said J.P. Morgan's Mr. Ahluwalia.

Write to Christopher Whittall at christopher.whittall@wsj.com

(END) Dow Jones Newswires

October 22, 2017 18:31 ET (22:31 GMT)