Collateralized Loan Obligations (CLOs) remain very much on the radar of leading investors in structured finance products, according to a roundtable discussion recently conducted by Standard & Poor’s.
But these buysiders are taking issue with how the market is changing in terms of rising leverage and increased proportion of covenant light loans.
“Considering current market conditions, CLO investment provides very strong risk-adjusted returns for investors,” said Serhan Secmen, a managing director at Napier Park Global Capital. “In the current market, it is difficult to achieve double-digit returns on an asset class similar to CLO equity.”
MetLife Director Loritta Cheng cited two other reasons: a highly liquid market and the ability to gain exposure to corporate credit, which is underrepresented among the major asset-backed sectors.
Expectations of rising interest rates are another source of appeal for CLOs, according to Kapil Jain, a senior analyst at Genworth Financial. “Being floating-rate instruments, [CLOs] have a higher degree of collateral performance transparency, which is beneficial for monitoring risk.”
The top of the capital stack is particularly well protected in the post-crisis era, given the requirements for more enhancement made by the rating agencies, said Allison Salas, a director at Deutsche Asset Management.
A few of the investors said the primary market offered more value than the secondary one. Spread is the salient reason; the others are better documentation and simpler structures as compared with older deals. While Salas has been focusing on the senior pieces, TIAA-CREF Director Aashh Parekh, along with Jain, are finding opportunities at the double- and single-A levels.
In terms of new features in the marketplace, Secmen said he welcomes two features surfacing in recent deals: B’ tranches and AAA's with step-up coupons. The former gives equity investors options to boost leverage, while the latter is an effective carrot for reticent investors.
But not all changes have been good ones in the eyes of the roundtable participants.
One troubling change: senior managers shifting over their fees to the equity tranche. “That is something we would obviously prefer not to see,” said Deutsche’s Salas. “I think it creates perverse incentives and effectively makes equity cash flows senior to debtholders.”
A few of the investors concurred that adding complexity to the market, even if it grows the size of the asset class, can be troubling.
More debt was another area of concern.
“Because of increased leverage and the covenant-lite structures, I think not only will the next downturn be worse, but it would affect different parts of the CLO capital structure,” said MetLife’s Cheng.
Covenant-lite loans now make up close to 70% of primary corporate loan issuance, according to the roundtable’s moderator, S&P Senior Director Jimmy Kobylinksi.