(Bloomberg) --Fund managers keen to restart the lucrative CLO-making machine are having to stretch the bounds of what counts as collateral behind these deals.
As their name suggests, collateralized loan obligations are designed to bundle up leveraged loans, a type of debt that typically gives holders the first claim in a default. Increasingly, though, CLOs are turning to another type of debt — junk bonds — for the security packages that underpin the investment vehicles that are sold to insurers and pension funds.
CLOs in Europe are now backed by a record 16% of junk bonds, according to data by Morgan Stanley. Nine percent of those portfolios have fixed-rate coupons, double the allocation from just three years ago.
To the uninitiated, the difference may seem like splitting hairs. Whether loans or bonds, the income stream they generate flows through to pay interest and principal on CLO bonds.
There are key differences though: loans rank higher in order of repayment in a default. They pay floating rates of interest, which closely match the interest schedules on the CLOs, whereas junk bonds often pay fixed rates.
"Managers would do well to remember it's a collateralized loan obligation — the operative word is 'loan'," said Andrew Lennox, a portfolio manager at Federated Hermes and a buyer of CLOs. "Bonds have always had a part to play in order to manage the liquidity of a CLO, but fixed-rate bonds will have interest rate exposure which isn't part of the thesis."
The CLO machine broke down last year as the supply of leveraged loans dried up. Loans typically emerge from private equity led buyouts — but many M&A deals were stranded in Europe earlier this year as valuation expectations diverged.
That's left CLO managers with a dearth of collateral, after demand returned for CLOs themselves. So they're resorting to junk bonds outside their usual remit.
The trend is much more eurocentric given limits on US deals, where the Fed restricts pools to a 5% allocation to bonds. The European Commission has looser limits, and CLO managers can typically allocate up to 30% to bonds. Some are looking to push it even higher.
"Some managers are pushing those buckets up to 35% versus 30%," said Laila Kollmorgen, a portfolio manager covering European CLOs at PineBridge Investments. "We're seeing a lot of that."
The vehicles are profitable for managers: they pocket yields of around 7% on the junk debt they invest in, while they raise money selling bond-like instruments yielding from anywhere between 6.23% and 13.42%, according to PalmerSquare's CLO indexes. So profitable, in fact, that hedge funds like the one founded by former Credit Suisse Group AG star trader Hamza Lemssouguer are entering the marketplace.
There are other reasons to supplement loans with junk bonds in a CLO pool. As they get closer to their maturity dates and investors expect to be made whole, junk bonds usually rise back towards face value, or 100 cents. By contrast, loans can have prices that are both lower and may be harder to discern because they trade less often. As CLO managers build up enough collateral to come to market, they store loans in warehouses, and the risk is that older loans fall in value.
For sellers of junk bonds, the demand from CLOs has been a boon. The share of the euro high-yield market owned by CLOs has risen to 9.5% from 5.5% 18 months ago, according to Morgan Stanley.
That's spurred a jump in issuance of floating-rate notes favored by CLOs. They account for about 15% of new junk bond issues this year compared with 7.1% in 2021, according to data compiled by Bloomberg.
"If you bring a new issue in high-yield FRN format, there will be heavy participation by the CLO community," Ben Thompson, head of EMEA leveraged finance capital markets for JPMorgan Chase & Co.
This year, British companies Iceland Foods and Travelodge Hotels Ltd. both issued their first ever euro floating rate notes to tap into CLO demand, according to people familiar with the matter. Spokespeople for the companies did not respond to requests for comment.
"CLO managers continue to dip into the bond market as loan market activity hasn't really picked up," said Vasundhara Goel, an analyst at Morgan Stanley. "Unless loan supply resumes, I believe this trend will continue."
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