Quest for yield revives hybrid loan/bond CLO structure
NEW YORK, Sept 7 (IFR) - The quest for yield has set the collateralised loan obligation (CLO) new issue market on fire in the US and reawakened a hybrid loan/bond animal that's been in hibernation for more than a decade.
CLOs -- which typically package leveraged loans into different slices of risk and sell them to investors as bonds with varying yields -- helped fuel the private equity leveraged buyout boom of 2006 and 2007. The instrument gave private equity firms the ability to cheaply finance loans for M&A activity via the capital markets.
Unlike real estate-linked CDOs, CLOs are underpinned by pools of corporate "leveraged" loans -- those made to low-rated companies.
Issuance in the sector peaked at nearly $100 billion in 2006, before investors fled structured finance products after the subprime mortgage debacle.
CLO issuance nearly halted in 2008, and barely re-emerged with only $1.2 billion sold in 2009 and $3.4 billion in 2010.
But as investor appetite for risk and yield returned over the last year, CLO issuance started to bounce back. Nearly $27 billion has already been issued year-to-date, exceeding the 2011 full-year total of $13 billion.
The re-emergence of the product is beginning to revive interest in riskier collateral profiles, which have not been seen since the inception of the asset class in the '90s, including larger collateral buckets for high yield and other riskier debt.
Thus GoldenTree, a leading manager of CLOs based in New York, recently completed a US$590m offering underwritten by Bank of America Merrill Lynch which has a maximum 40% bucket for high-yield bonds, second lien and unsecured leveraged loans.
The GoldenTree deal was a refinancing of an old portfolio of leveraged loans and bonds, rather than a response to demand for more aggressive structures than today's typical CLO with 90-95% of its collateral in secured leveraged loans.
Yet the fact that it found buyers has put a flag in the ground for other asset managers looking at ways to juice up their CLO returns by adding higher-yielding junk bonds.
California-based Peritus Asset Management, for instance, is trying to put together a US$300m CLO with a 50/50 leveraged loans/high-yield bonds split in collateral.
It's understood Peritus is hoping to design something with returns of equity of as high as 20%, compared with the 13-15% on today's more conservative CLOs.
"Loans have a higher recovery rate than bonds; there's no question of that," said one asset manager of high-yield bonds.
"But it doesn't seem to make sense to ignore a very significant high-yield bond market where you can get similar risk reward as you can in the loan market and probably with better yield attached."
A HARD SELL
Having high-yield bonds in a CLO is a hard sell, however, and may be extremely costly if the 250 basis point (bp) spread GoldenTree paid on its triple A tranche is an accurate guide.
Recent deals, like a US$718.9m CLO for Ares Management underwritten by JP Morgan, offered a trading spread of 150bp over Libor for the triple A portion, rising to 825bp over Libor for the lowest rated BB slice.
"Most investors much prefer loans (as collateral in a CLO) than high yield bonds," said Ratul Roy, head of structured credit strategy at Citigroup.
"Conventional CLOs have rarely ever defaulted... but of the 40 out of 4,118 tranches that did default (since the late 1990s), most were in structures that invested heavily in high-yield bonds, whose value deteriorated significantly in the stressful credit environment between 1999 and 2002," he said.
CLOs make money based on the difference between the liabilities spreads that they pay to their investors and the spreads they earn on the underlying loan assets.
Since 2010, liabilities spreads on all parts of the CLOs' capital stacks have been trending lower, although they are still wide compared to liabilities spreads on the vintage CLOs from the bull market of 2006.
Tighter Triple A spreads on CLOs, therefore, are key to making the economics of the product attractive for investors and issuers alike.
In recent months the return to equity investors has come under some pressure because spreads on CLOs tranches have remained sticky, at around 150 to 153bp on Triple A slices, at the same time as increasing demand for the leveraged loans has driven spreads tighter on the collateral.
What's more, the universe of CLO buyers is tiny compared to the leveraged loan market. Although that CLO buyer base is growing, it is still not that large, which means that CLO spreads have lagged the tightening seen in the underlying leveraged-loan spreads.
This recent slowdown in CLO Triple A spread tightening has crimped equity investors' returns, making the prospect of potentially riskier deals containing high-yield bonds -- offering up to 20% in equity returns -- quite enticing.
One problem: The goal of juicing equity returns must be carefully balanced with the preservation of tightened Triple A spreads.
Accomplishing the successful sale of CLOs has always been a balancing act between pleasing Triple A investors and equity investors, two very different groups whose interests are not always aligned.
Without ample interest from both, a CLO cannot sell.
The GoldenTree and Peritus transactions are timely in that they may bring equity holders in the CLOs increased returns during a time when their returns are slipping, but structuring such a deal without affecting the ever-important Triple A spreads is not always easy.
Therefore, the 250bp Goldentree paid on its US$286m worth of Triple A tranches seemed a hefty price for the inclusion of its 40% higher-risk bucket.
It remains to be seen whether these hybrid CLOs can somehow keep their Triple A spreads tighter.
Securitization specialists say it might be possible, since risk can be dialed up and down in a collateralized structure by finessing factors like diversification, the number of tranches and the number of different ratings.
Moreover, the cost of including high-yield bonds in a CLO has a lot to do with the skill of the asset manager in finding the right sort of bonds that offer the same risk/reward as a leveraged loan but yield more, simply because of the dynamics of the bond market.
Hybrid structures may be able to balance increased equity returns with tightened Triple A spreads in the future. For instance, some experts argue that the wide Goldentree Triple A pricing is linked to investors' fears about bond inclusion in CLOs based on a junk-bond market of the past, which has little bearing on the quality of today's high-yield bonds.
The CLOs with high-yield bond exposure written in the late 1990s and early 2000s were caught up in a surge of defaults that peaked at around 11% in 2002.
Now default rates are around 2.8% and highly aggressive deals are the exception to the rule, CLO analysts say.
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