We are currently going through a difficult economic environment – with rising interest rates, a credit squeeze, inflation and currency volatility, explains Rob Reynolds, md and head of CLOs at Pemberton.

After years of cheap money, investors are naturally being more cautious and selective about where they invest their money.

CLOs are one product that has consistently served as a buffer during times of economic distress. But being based on loans and concerns about rising default risk, investors might ask whether they can still fulfil this role.

Research¹ shows that the default rate of loans in CLO portfolios is less than half the reported level for the loan market as a whole. Default rates for CLO tranches themselves are materially lower again.

This is likely due to the way CLOs are structured and managed. For example, there are predetermined parameters which limit individual position sizes (irrespective of the size of the underlying debt tranche), restricting investment in the riskiest loans. They also include a range of portfolio metrics (for example, weighted average spread, weighted average rating, over-collateralisation tests) which protects note holders by providing a cushion. Furthermore, as CLO portfolios are dynamically managed, they can reduce exposure to deteriorating risk.  

Between 1996 and 2020, there were a total 62 note defaults out of 16,806 CLO notes issued.² This is equivalent to a 0.4% total default rate over 24 years. These defaults were in all in respect of CLO 1.0 vehicles (defined as those issued before 2010). Where defaults have happened, S&P research shows they tend to be concentrated among only a small handful of CLO managers. The vast majority of these managers have since been unable to issue further CLOs. Indeed, investors’ memories are long. 

S&P found that problems arose mostly after the reinvestment period during the portfolio’s amortisation phase. The impact of rating downgrades and defaults were magnified as portfolios shrank in size owing to the concentration of fewer assets. Good assets being repaid left a tail of poorer quality assets, while at the same time the cost of the structure increased, reducing the cushion.

So, what’s the outlook for CLO 2.0?

Their historic performance and resilience speak for themselves, indeed most recently through the height of the pandemic, but there have also been structural changes to CLOs since 2010 (known as CLO 2.0) that, in our opinion, suggest they will continue to withstand current market conditions.

S&P’s research points to them having a higher proportion of senior secured loans, no synthetic products, no structured credit holdings and a higher triple-C tolerance. This makes for a more stable, secure product that is built on the basis of withstanding shocks. 

CLO 2.0 vehicles also typically have higher levels of subordination, giving greater protection to note olders, and shorter non-call periods which allow managers to more easily adapt to changing market conditions. 

Possibly the most dramatic change, in our view, was the introduction of the concept of 'risk retention', where the manager is required to invest 5% into the CLO. The objective of this was to ensure that the interests of CLO noteholders and the collateral manager are aligned.

With all this in mind, what can we expect in the months ahead? We believe CLOs will likely continue to remain a popular asset for investors looking for returns in difficult market conditions. Indeed, those CLOs that are still in reinvestment mode may be able to take advantage of current market conditions, with secondary assets trading at a discount to build par and increase par value coverage. However, taking on board the lessons from the first generation of CLOs, managers remain on notice to manage tail risk in amortising vehicles and ensure that their products continue to offer stability in a difficult time.

Sources

¹Meredith Coffey of the LSTA dated 13 July 2022 (CLOs: Superior Performance - LSTA)

²Default, Transition, and Recovery: 2020 Annual Global Leveraged Loan CLO Default And Rating Transition Study | S&P Global Ratings (spglobal.com)