While some market participants are predicting CLOs will cool down following this summer’s rally, many believe pools of mezzanine debt within CLOs will remain red hot.
Investors who bought mezzanine CLO debt earlier this year have, in many cases, doubled their initial investment over the course of just a few months, according to analysts at Citigroup. Mezzanine tranches have even performed better than triple-A loans, which haven’t seen the surge in prices that mezzanine debt has. Investors who invest in diversified pools of mezzanine debt can achieve returns of roughly 20%, according to the Citi analysts.
The surge in mezzanine debt has been directly related to the rally in the loan market. The Standard & Poor’s/LSTA Leveraged Loan 100 Index on Sept. 14 reached its highest point since its inception in January 2002, recording a year-to-date return of 43.59%. Meanwhile, the average bid price is in the 80s, up more than 35% over this time last year. And average triple-C rated loan price is in the low 70s, double the all-time low of 35.9 in late March.
CLOs have done slightly better than the broad loan market in terms of defaults, partly by avoiding recent highly levered loans such as LyondellBasell and Chrysler. As of Sept. 15, the average default rate within U.S. CLOs stood at 5.6%—a decrease of 0.3% compared to last month, according to Citi. The drop is explained by the exit of companies such as Quebecor and GM from bankruptcy protection. But overall, the biggest factor has been an improvement in confidence, the analysts added.
But one of the main reasons opportunities in the mezzanine space are so prevalent is that, during the credit crisis, many investors unloaded their mezzanine assets, analysts at Morgan Stanley said. “We think [the unloaded mezzanine debt] represents an opportunity to buy cheap assets on a hold to maturity basis,” they said.
The opportunities, analysts say, pertain especially to distressed mezzanine debt. “The stigma of complexity has faded and the trade performance thus far has spawned broader investor interest,” the Morgan Stanley analysts said. However, “a pick up in defaults could translate to realized losses.”
Investors should be acutely aware of two factors when considering investing in these assets, the Morgan Stanley analysts said. For one, there is the structure of the tranche — the recovery expectations, maturity, coupon and underlying portfolio. The other factor pertains to the quality of the collateral.
Mezzanine debt was attractive in the last down cycle because, like today, it provided investors with spreads that were significantly higher than what other assets offered, according to the Morgan Stanley analysts. However, unlike the last downturn, new ratings models will rate mezzanine debt closer to high yield and will demand various stress tests.
The good news is that today the spread differential, which is also called the excess spread, between CLO assets and liabilities has increased significantly. This means that even junior mezzanine CLO tranches can withstand a wave of defaults and downgrades. In many transactions excess spread is now more than 200 basis points, the widest it has ever been, according to the Citi analysts.
While the rally in the loan market has already gone a long way, some market participants actually think the rally can go further because factors like the excess spread are a positive sign.
“CLOs got a bad rap because of the problems CDOs—subprime mortgages—got into,” said Steven Bavaria, managing director of leveraged finance for DBRS. “Once the market realized that CLOs are simpler than their CDO cousins, it was able to distinguish better between the two assets types, and CLOs, previously a beaten down asset class, have popped back up. The fact that the leveraged loans that CLOs hold have increased in average market price from around 65-70 to about 90 has really helped boost CLO values as well.”
The analysts at Citi suggest investors should purchase diversified portfolios to capture the most yield. If investors do this, it will positively impact mezzanine tranches because it will give these tranches a cushion. Mezzanine tranches are typically thin because most portfolios are bulked up with other secured debt and equity.
However, not everyone is keen on this strategy. “We’re an advocate of the ‘do your homework’ theory rather than diversify and hope for the best across asset classes,” said Gene Phillips, a director at PF2 Securities Evaluations and author of The Corporate Loan and CLO Conundrum. “We’ve already seen how asset classes can move together. In the CLO mezzanine space, you need to be accurate, not diversified. You need to read the documents, analyze the collateral, understand the manager’s strategy and behavioral tendencies.”
An analyst at a major U.S. bank added, “Mezzanine notes generally have more upside, but more care must be taken in selecting which deals to buy, as there is more risk down the capital structure. This risk comes in two forms: General or systemic. These tranches would be more susceptible to negative economic or credit news, and deal specific idiosyncrasies, specifically relating to the risks that the structure or manager can shut off the cash flows or lock you out.”
Indeed, caution regarding mezzanine CLO tranches is warranted. For example, in August, Kohlberg Kravis & Roberts cancelled almost $300 million in mezzanine notes within two CLOs it managed. KKR did this so the CLOs would be in compliance with their overcollateralization tests.
Shortly thereafter, Moody’s Investors Service issued a special report, saying it doubted this kind of event would become widespread, because most CLOs have multiple unconnected holders of mezzanine debt. However, Moody’s said that it is possible more cancellations could happen.