While it's always been along for the ride, high yield collateral was all but relegated to the back seat as CDO investors experienced a bumpy ride, thanks to record downgrades over the last 18 months. Although most investors are aware that loan deals have performed better than bond deals, analysts are now comparing loan performance to investment grade-backed CDOs, a finding that says CLOs have found paradise by the dashboard light.
CDOs packed with high yield bonds (HYB) comprised the large majority of the downgrades witnessed last year. Yet investors shied away from the high yield collateral class in general. In the meantime, high yield loans (HYL) have turned in a consistently upbeat performance. Over the last six years, research from UBS Warburg found that HYL CDOs have outperformed not just HYB-backed CDOs, but have solidly outperformed corporate debt-backed CDOs.
"That's been an amazing aspect. You would expect worst credit performance from a speculative-grade portfolio, but looking at the data, high yield loan-backed CDOs have had about the same level of O/C loss and WARF deterioration as investment-grade bond CDOs," said Douglas Lucas, director, CDO strategy, for UBS. "But HYL CDO subordination is about three times as much as in an investment-grade bond CDO," he noted.
Furthermore, CDO investors should be turning their attention to HYL CDOs, Lucas said.
By every performance measure -over collateralization loss, increase in WARF and rating downgrades - HYL-backed CDOs have outperformed HYB-backed CDOs. "There's no contest between the two," Lucas said.
Sparked by queries from investors who appear less familiar with loan collateral than bond collateral, UBS looked into why HYL CDOs posted a better performance than their HYB brethren, in a recently published research piece.
There has been a drastic difference in the amount of new issuance harnessing each of the two high yield collateral types over the last two year. According to UBS research, HYL-backed CDO issuance totaled approximately $40 billion over that period while HYB-backed CDO issuance was roughly $22 billion.
In short, it boils down to the superior credit performance of senior secured loans and the conservative structure of loan-backed CDOs. Loan spreads have widened over the last five years and compared to corporate bonds, loans are less likely to default and have higher recoveries if they do default. Research from the firm notes that ratings on loans are more timely and accurate compared to bond ratings.
"Rating agencies have a bias against making rating changes. Thus, if a company's fortunes have changed, positively or negatively, its ratings do not necessarily fully reflect that current credit condition. Many companies taking out loans, however, do not have existing ratings, so there is no ratings history to restrain a rating analyst's judgment," the UBS report states.
The structure of a HYL-backed CDO is more conservative when compared to other CDO vehicles, with respect to the amount of subordination that's required in comparison to the collateral's default risk and default severity, Lucas noted. An interesting aspect of loans is their lower default probability, on top of their lower default severity.
The leveraged loan market itself has seen significant changes over the last six years as institutional investors have taken up a larger role. According to UBS, institutional investors now purchase more than 40% of syndicated high yield loans with banks purchasing the remainder. In the first quarter of 2003 those numbers were nearly equal, as institutions made up 47% of loan purchases. Therefore, appetite for this credit type by institutions has helped drive new issuance from CDOs harnessing leveraged loans collateral. According to UBS, CDOs purchased 64% of institutional loans over the last 12 months, with those loans ranging from an average of $200 million to $1 billion in size.
For a market consumed with downgrade fears, investors should note there have been far fewer downgrades for HYL CDOs than for HYB CDO tranches. UBS found, for example, that 73% of HYB CDO tranches issued in 1998 have been downgraded versus 29% for HYL CDOs.
"Based on the very different patterns of O/C and WARF deterioration, I expect this trend will continue," said Lucas.
While the term "senior secured" should never be considered synonymous with credit quality, CDO investors should note that there is one powerful yet simple feature leveraged loan collateral tout over high yield bonds. Loan lenders have more power than bondholders, as they have a more secured position in the borrowers assets.
Furthermore, loans have substantially more covenants packed into their deals than bonds and bond terms suffer from loose definitions of tests, making them inadequate, Lucas and his team found.
"With loan spreads wide, loan credit quality high and good loan-backed CDO performance, spreads and supply, this is an ideal time for CDO investors to look at high yield loan-backed CDOs," Lucas concluded.