Hunt For Yield Fuels Boom in CLOs

By Christopher Whittall Features Dow Jones Newswires

As investors hunt for yield in global markets, acronyms are back.

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Complex structured investments got a bad rap during the credit crunch, and products such as collateralized debt obligations, or CDOs, entered financial-crisis lore. Ten years on, return-starved investors are overcoming their skepticism to pile back into securities that rely on financial engineering to juice returns.

Volumes of CLOs, or collateralized loan obligations, which slice and dice risky, leveraged loans, hit a record $247 billion in the first nine months of the year, according to data from J.P. Morgan Chase & Co.

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.

In contrast to CDOs, which are similar-sounding but actually were more toxic, CLOs 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.

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

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"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.

CLOs carve up a portfolio of bank loans to highly indebted companies into slices of different securities. 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 the CLO stack 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.

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.

Global CLO volumes in 2017 are already 82% higher than last year's total, according to J.P. Morgan, thanks to a wave of CLO refinancings and $97 billion in new deals coming to market.

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-heavy 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 ten 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 pre-crisis," said J.P. Morgan's Mr. Ahluwalia.

(END) Dow Jones Newswires

October 22, 2017 08:14 ET (12:14 GMT)