Charles Kobayashi, portfolio manager at BlueMountain Capital Management, answers SCI's questions

Q: How and when did BlueMountain Capital Management become involved in CLO management?
A: BlueMountain Capital Management was founded in 2003 with a focus on the credit derivatives and correlation markets. By 2005, the firm had expanded into cash loan assets, given their secured nature and low volatility. We also looked at launching a CLO to benefit from the associated leverage and secured recovery.

I was hired in April 2005 to establish the firm's loan/CLO effort, having previously managed about US$2bn of structured products - including CLOs and CDOs - at Credit Agricole Indosuez, before it merged with Credit Lyonnais. When I joined, BlueMountain had US$300m in loans under management; now, including CLOs, we have US$3bn.

Our first CLO issuance was in November 2005, sized at US$512m. We set out to opportunistically grow the business in a calculated way, particularly given our view that CLO equities were an attractive investment opportunity. We brought additional CLO transactions to the market in 2006 and 2007.

Despite the crisis, our three pre-crisis CLOs have performed extraordinarily well through the cycle. The lowest Moody's rated tranche is Ba3.

After the crisis hit, we launched a long-only loan fund to take advantage of the dislocation in the market: pricing at that time was attractive mostly because of technical, not fundamental, issues. Because of TRS unwinds and de-leveraging by market participants, loan prices dropped to the low-60s in 2008.

Our first loan fund was launched in April 2009 and the deal was called in January 2010, having returned 35% IRR in an eight-month period. We had targeted a high-teens to low-20s return over a two- to three-year timeframe, but the market recovered much quicker than anticipated.

We also manage some separate accounts investing in long secured/short unsecured.

Q: What are your key areas of focus today?
A: More recently, we discussed a long-only fund, but decided that the best way to invest in the sector at the present time is through a CLO. Investors these days are increasingly nervous about mark-to-market risk in volatile markets.

We launched our latest transaction - the US$361m BlueMountain CLO 2011-1 - at the end of July. The deal is fully ramped and has outperformed the targets we set at closing.

We have been in discussions with underwriters about a new CLO and expect to launch one in Q4 or 1Q12. The timing depends on the economics because ultimately the transaction needs to be accretive to equity. We're ready to access the market, but are waiting for the right entry point.

Q: How do you differentiate yourself from your competitors?
A: The depth of our research bench differentiates BlueMountain from other CLO managers: we employ 18 fundamental analysts, which is more than other CLO managers. Investment decisions are based on a bottom-up approach that focuses on the entire capital structure, not just a specific tranche.

This approach is a major differentiator - especially through the downturn - because it provides us with relative value signals ahead of our competitors, which allows us a first-mover advantage if our view of default risk and recoveries change based on these signals. This is in contrast with other CLO managers that typically only look at the secured loan space.

Q: What is your strategy going forward?
A: We expect market volatility to continue for the next few months. To take advantage of the dislocated market, we are executing new trades.

Secured is a cheap asset at the present time, so we are purchasing both high and low beta single names. We have a bearish view on unsecured recoveries and are currently shorting unsecured versus secured to capture this opportunity.

Q: What major development do you need/expect from the market in the future?
A: New issue loan spreads have cheapened significantly and the underlying collateral quality has improved, which is benefiting most CLO structures. If a manager has an existing vehicle, this widening has helped fuel asset purchases in the secondary market. Certain loans in the market are trading at attractive valuations as technical reasons have sparked a sell-off.

In terms of liabilities, triple-A CLO spreads at 150bp still yield good IRRs for equity holders because the underlying assets are wider. But it's a question of being able to place the liabilities at particular levels. A number of managers are due to price deals in the next few weeks and it will be a good indication of where the market stands.

Nevertheless, the US primary CLO market is fairly healthy at the moment and the well-regarded managers have been able to price transactions. Although volumes won't be as sizeable as expected in May, a solid pipeline remains for 4Q11 and 1Q12.

The choppiness is a result of broader credit market volatility, which is causing everyone to take a breather. But the underlying loan market is still strong - we're not expecting a spike in default rates any time soon.

The secondary CLO market has widened in tandem with the broader credit market. Decent appetite for equity and triple-A tranches remains, but mezzanine tranches have widened significantly.

There is less demand for this part of the capital structure because of the volatility and low current income. While the DM on a double-B piece is attractive, at around 1300bp, the coupon is low.

High quality equity has performed very well recently, since it pays large upfront cashflows of 28-32 points and annual IRRs in the high-teens. Triple-A spreads have widened but remain a solid investment. In addition, recent Moody's upgrades have incentivised banks and insurance companies to invest in senior CLO tranches.

CS