It’s taken several years and rock bottom interest rates, but more and more investors are taking a gander at the riskiest tranches of collateralized loan obligations, known as the equity. And they like what they see.
When the financial crisis struck, the biggest buyers of CLOs, most notably SIVs or structured investment vehicles, disappeared, and issuance ground to a halt. When the market slowly and sporadically recovered during 2010 and 2011, it was because some managers were able to find a small number of buyers for the least-risky, triple-A rated tranches and hold on to the riskier tranches themselves. Most of these managers were affiliated with private equity shops and so had deep pockets.
Some of the latest deals still get done this way, especially those managed by CLO managers that don’t have much of a track record. But it is becoming increasingly easy to place the equity with outside investors, market participants say.
Indeed, with a market recovery perceivably in full swing—with issuance this year heading toward $40 billion, or three times as much as 2011—not only has the interest in CLO equity grown but new kinds of investors have been stepping up.
"Over the last two years, Morgan Stanley has placed $250 million of CLO equity to third party investors across more than 20 accounts," Sajid Zaidi, head of CLO structuring at Morgan Stanley, said Monday. He was speaking at one of the six panels at Information Management Network’s securitization conference in Miami that was dedicated to CLOs.
Managers of CLOs and bankers working in CLO structuring have been seeing interest in CLO equity from hedge funds and pension plans steadily increase as the market has recovered. However, now other institutional investors such as foundations and endowments, and even family offices, are jumping on board, Zaidi said.
Investors in other structured products, notably residential mortgage backed securities, are taking a look too. “I would be surprised if we don’t see significant cross-over bid,” Richard Hill, a CLO strategist with Royal Bank of Scotland said on another panel. “I think the number of RMBS buyers that are attracted to CLOs is going to grow exponentially.”
The reason for this is simple: With the Federal Reserve keeping interest rates near zero in an attempt to boost the economy, investors are on a hunt for yield, and CLO equity offers double digit returns.
“I cannot find another asset class offering risk-adjusted returns of 10% to 12%,” Hill said.
Still, market participants continually stress the importance of investor education, even now.
Joe Moroney, a portfolio manager with Apollo Management, who was participating at one of the panels, said his firm often gets inquiries from investors interested in what sounds a lot like CLO equity—double digit returns, secured collateral, etc. “And we say, oh, you want CLO equity. And they say, ‘no, no, no.’ It’s been a long process to educate,” Moroney said
Interest in other parts of CLOs capital structure has increased substantially, too according to market participants. For example, regional U.S. banks are taking a shine to the triple-A tranches.
Spreads on new-issue CLOs, while they have tightened recently, are in the area of Libor plus 140 bps for triple-A paper (versus 150 bps during the summer).
“As most other triple-A securitized products are well inside 100 bps, CLO triple-A’s offer significant value, especially in the context of bank return on equity,” JPMorgan analysts noted in a Sept. 22 report.
And market participants expect the interest in CLOs to continue to grow.
“I think it will only accelerate,” said panelist John Clements, a managing director at Citi. “We’re going to see a snowball effect.”