It’s taken several years and rock-bottom interest rates, but more and more investors are taking a gander at the riskiest tranches of CLOs, known as the equity, according to participants at Information Management Network's annual ABS East conference.
And apparently buysiders 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 — 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 on Oct. 22. He was speaking on one of the six panels dedicated to CLOs at ABS East.
Managers of CLOs and bankers who structure these funds 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 crossover 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. And that’s after quite a bit of tightening. The equity yields on generic 2006–2007 vintage CLOs were in the 20% to 30% range at the beginning of the year, according to RBS. Still, market participants continually stress the importance of investor education, even now.
Speaking on a panel, Joe Moroney, a portfolio manager with Apollo Management, said his firm often receives 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 basis points for triple-A paper. That compares with 150 basis points during the summer.
“As most other triple-A securitized products are well inside 100 basis points, CLO triple-As offer significant value, especially in the context of bank return on equity,” JPMorgan Securities 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.”