Analysis: They're back! Yield hunt pushes funds into CLOs, CDOs

Fund managers are increasingly eyeing riskier exotic assets, some of which haven't been in fashion since the financial crisis, as yields on traditional investments get close to rock bottom.

Returns from investments in "junk" bonds, government guaranteed mortgage securities and even some battered euro-zone debt are plunging in the wake of global central bank policies intended to suppress borrowing costs.

In particular, the Federal Reserve's latest move to juice the U.S. economy by purchasing $40 billion of agency mortgage-backed securities every month is forcing some money managers who had previously been feasting on those securities to get more creative. The only problem is they may be getting out of their comfort zones and taking on too much risk.

"I would not be surprised if some managers are reaching outside of their expertise for a few extra basis points," said Bonnie Baha, a portfolio manager for DoubleLine's Global Developed Credit strategy.

To keep performance high, credit-focused managers are moving back into some of the risky assets that got tarnished during the financial crisis like collateralized loan obligations, or CLOs, securities cobbled together from pools of corporate loans.

But unlike the past when managers amped up returns by buying CLOs and risky "subprime" securities with borrowed money, leverage levels are remaining low at least for now.

New York-based BlueMountain Capital Management, which manages $10 billion in hedge fund and CLO assets, has become increasingly focused on more complex and illiquid structured credit. But the fund is also cautioning investors the payout on these riskier, high-yielding assets may take longer than more traditional investments.

"If you're willing to go out more into more illiquid, structured or complex trades, there's more opportunity, and potentially mid-teen returns," said BlueMountain co-founder Stephen Siderow.

BlueMountain is even venturing back into CDOs, the much-maligned investment product that became synonymous with the housing bust and the financial crisis. In March, the hedge fund, purchased a portfolio of synthetic collateralized debt obligations, from French bank Credit Agricole.

The firm's flagship $4.8 billion BlueMountain Credit Alternative fund rose about 12 percent in the first eight months of this year.

The search for yield is understandable with the benchmark 10-year U.S. Treasury at 1.61 percent and government guaranteed mortgage debt - the securities the Fed is purchasing - yielding just 1.50 percent. Even corporate junk bonds aren't so high-yield these days, with those securities yielding 6.36 percent on Friday, after hitting a record low of 5.98 percent last week.

Even seasoned investors that don't exclusively play in the credit markets are working extra hard for yield.

Many money managers remain apprehensive about the ability to generate big returns for their investors, despite the rally in U.S. stock prices this year, given expectations for weaker earnings, a global economy that remains far from buoyant and the ever-looming debt crisis in Europe. These macro-economic headwinds are problematic not just for investors in the fixed income universe, but for those who also specialize in equities, currency and commodities.

A $3 billion macro-focused hedge fund owned by Brazilian bank BTG Pactual, which was up 17.4 percent in the first eight months of the year recently told investors it is looking to "pick up additional yield."

In an investor letter, BTG's GEMM Fund said it now prefers "a cluster of higher-yielding, higher beta sovereign names that compensate investors appropriately for liquidity and credit risk" rather than "popular long-duration vanilla benchmarks."

So far this year, hedge funds specializing in securitized credit and mortgage-backed securities have benefited the most from the Fed's loose monetary policies. Hedge fund tracking firm eVestment|HFN said that as of August 31 securitized credit-focused funds were up 12 percent for the year, followed by mortgage-backed funds, which are up 10.67 percent.

One of the top performing credit-oriented hedge funds this year is MetaCapital Management, a $1.4 billion fund led by former Lehman Brothers trader Deepak Narula, which was up more than 29 percent through August.

Pine River Capital Management's $3 billion Fixed Income Fund gained more than 23 percent for the year through to August 24, while its roughly $900 million Liquid Mortgage Fund rose almost 19 percent over the same period, according to data from HSBC Private Bank.

Meanwhile, the average hedge fund was up only about 4 percent during the first eight months of the year, lagging well behind the broader stock market, which gained 13.5 percent through August.


Mark Okada, the co-founder and Chief Investment Officer of the $19 billion Highland Capital Management, said bank debt, CLOs, and some mortgage securities will provide the best returns in credit as the Fed continues to depress yields in the United States until the job market springs back to life.

"The government is in their market," Okada said of MBS, which has been so profitable for hedge funds this year. "The government isn't in my market buying loans and bonds."

That translates into big opportunities for Highland and other managers who have the expertise - and stomach - for such exotic securities. Of the $19 billion in assets Highland manages, $14 billion is invested in CLOs.

The firm's investments in $1.2 billion of secondary CLO assets are returning 27 percent this year, a person familiar with the firm said. Returns for the bulk of their CLO holdings could not be determined.

The issuance of new CLOs fell off a cliff in 2008 during the financial crisis, after reaching a peak of roughly $100 billion in 2007. CLO activity has slowly been ticking back up, and JP Morgan research analysts forecast $35 billion in new CLO supply this year, almost triple the $12.6 billion issued in 2011.

Highland Capital is investing in both new and legacy CLO assets.

JP Morgan fixed income analysts said CLOs are appealing because it "has become increasingly difficult to find high-single-digit to double-digit loss-adjusted yields" in the traditionally higher-yield residential- and commercial mortgage backed securities markets.

The main risk of investing in CLOs is "a broader market selloff, which would erode CLO relative value," the analysts wrote earlier this month. But those dangers are offset by the commitment of central banks to prop up global financial markets- - widely known as the "Central Bank put" - and the hunger for yield in general, they added.

If the economy were to severely weaken, CLOs could be hit hard as they were in the financial crisis by a rise in corporate defaults. Many of the loans in CLOs were sold to finance leveraged buyouts for heavily indebted companies.

"The problem with 'riskier' products is that risk - in this case, credit risk - could come back with a vengeance and manifest itself in ways that the market is largely oblivious to right now," DoubleLine's Baha emailed. "Default rates are low and due to the liquidity in the credit markets spreads have tightened considerably even in the face of mediocre to worrisome global economic data. It's like investors are thinking that nothing 'bad' is ever going to happen again."

While credit funds are indeed sniffing around more highly-levered products like asset-backed securities, CLOs and derivatives, prime brokers and traders say the demand for leverage in the form of borrowed cash from Wall Street lenders has not been high.

But with the Fed's intention to keep its zero-interest rate policy in place until at least mid-2015 and other major central banks, including the European Central Bank, flooding their economies with liquidity, that all might change.

The Fed's buying "will suck out an enormous supply of bonds from the market," said Bank of America Merrill Lynch's MBS/ABS strategist Chris Flanagan in a research note. "It is officially 'game on' in terms of access to supply."

(Reporting By Katya Wachtel; Editing by Jennifer Ablan, Matthew Goldstein and Martin Howell)