How CLOs can deliver high returns

As the recent market correction has highlighted, excess liquidity has compressed yields, challenging income investors to take additional risks for a small increase in returns.

The securitisation of US bank loans as collateralised loan obligations (CLOs), on the other hand, is an example of a credit strategy potentially able to generate returns in the 10-14 per cent range for income note investors taking advantage of market inefficiencies.

At the moment, an investor is paid approximately 0.7 per cent more to invest in unsecured high yield debt instead of senior loans of a similar rating, or 4.5 per cent more to invest in CCC high yield bonds instead of BB-rated ones.

Three years ago, they would have received double these premia. Fundamentally of course, this higher yield is the price of the risk of investing lower down the capital structure or down the credit quality spectrum.

As an alternative, certain market inefficiencies have created income opportunities for investors.

Liquidity, for example, is probably overpriced. The ability to hold investments for between three and five years has the potential to enhance returns significantly.

At the other end of the spectrum, banks, money market funds, Ucits funds and other large pools of capital desperately seek highly rated, liquid debt in which to place excess liquidity. Securitisation markets can, as a result, finance certain assets to maturity on a non-recourse, non-mark-to-market basis at very attractive terms for investors.

The securitisation of US bank loans as CLOs is based on the CLOs’ ability to issue long-term (over 10 year), non-mark-to-market, non-recourse debt to finance diversified portfolios of senior bank loans to maturity.

Typically, the obligors are large US companies for which extensive financial information is available. To attract buyers and reduce the cost of financing, CLO debt is issued in tranches that can be rated (up to AAA) by multiple rating agencies and issued as floating-rate notes with a fixed spread. Both loans and financing are floating-rate and currencies are matched.

CLOs operate as financing companies: every quarter the CLO receives income from the loan portfolio, pays the interest due on the financing and expenses and pays any remaining available cash (effectively its funding margin) to investors in its income notes.

The income note return is primarily a function of the manager’s ability to avoid non-performing loans in the portfolio, not the mark to market of the loans – as, regardless of the market price of the loan, the borrower has to pay interest.