You Say Goodbye, I CLO
Central bankers often lower interest rates in times of economic weakness, hoping to encourage people and corporations to boost a flagging economy by purchasing things like houses, cars, and equipment.
That’s just what happened in December 2008. The Federal Reserve lowered short-term interest rates to between 0 and 0.25 percent and started buying longer-dated debt to drive down long-term interest rates.
But while low interest rates are good for borrowers, they make life a bit more difficult for investors who want to earn the highest possible returns on their fixed income investments. After six years of ultra-low rates, some investors have gone looking for higher returns in riskier assets, including collateralized loan obligations, or CLOs.
What Are CLOs?
At its core, a CLO is a security made up of loans to corporations that usually have relatively lower credit ratings. Leveraged buyouts, in which a private equity firm typically borrows money to purchase a controlling stake in a company, are a common source of CLO loans. After the loans are made, they’re sold off to a manager, who bundles them together and then manages the consolidations, buying and selling loans as he or she sees fit.
A CLO manager raises money to buy the loans by selling debt and equity stakes to outside investors in slices called tranches. These different tranches are not created equal, but rather exist on a spectrum of risk, along with other differing characteristics.
Think of everyone who owns a piece of the loan pool as standing in a long line. Those at the front of the line would get repaid first if any of the loans in the pool go into default, but they receive lower interest payments than those at the back of the line. The people further back are paid more for taking a greater risk that they would not be repaid in the event of losses in the underlying loan pool.
Typically, a CLO includes both debt tranches and equity tranches. The debt tranches are similar to bonds – they have credit ratings and offer regular coupon payments for a period of several years. Interest rates may be set or “floating,” meaning they vary with prevailing interest rates.
Debt tranches have first dibs on payments from the underlying loans, though here again, there are important differences within the group. Senior tranches have a higher-priority claim to payments (and receive lower interest payments) than junior tranches (which receive higher interest payments).
Equity tranches are the riskiest piece of the CLO puzzle. They have no credit ratings, are last in line for payment, and thus are the first to suffer losses if the underlying loan portfolio falters. Though equity tranche investors are simply paid whatever cash is left over after the debt investors have received their interest payments, they typically earn a higher return than debt tranche investors do.
CLOs Back in Style
CLOs fell out of favor immediately after the financial crisis, but they’ve been gathering momentum in recent years. Some $60 billion in CLOs have been issued so far this year, down slightly from the $64 billion issued over the same period last year, according to Standard & Poor’s Capital IQ. Still, to put that number in perspective, CLO issuance didn’t even hit $3 billion in the year-and-a-half between the last quarter of 2008 and the first quarter of 2010.
The typical CLO buyer is an institutional investor such as a hedge fund or pension fund. This year, Japanese pension funds and other institutional investors in particular have received widespread attention for investing in American CLOs.
In one example, $249 million of a $331 million CLO managed by Guggenheim Partners Investment Management was transformed in April into yen-denominated bonds to make it easier for Japanese investors to buy. Japanese Prime Minister Shinzo Abe has encouraged government pension funds, which have traditionally invested in Japanese government bonds, to shift their portfolio allocations to domestic equities and foreign investments.
Individual investors might be exposed to CLOs through pension funds or other investment funds, such as mutual funds. Some mutual funds include CLOs alongside other investments, while some closed-end mutual funds invest exclusively in CLOs. (Closed-end funds raise a fixed amount of capital during their initial public offering and do not issue new shares later on. Most mutual funds are open-end funds, meaning that they can issue additional shares in the future.)
It’s worth noting that insurance companies tend to snap up the most senior debt tranches of CLOs, which are the ones most likely to be repaid in times of trouble, according to the CFA Institute, the trade group for chartered financial analysts. Hedge funds, money managers and pension funds generally take the next highest-rated debt tranches.
Many of the mutual funds that offer investors CLO exposure invest in junior debt tranches and equity tranches. Thus, individual investors investing in those funds often are gaining exposure to the very riskiest portions of these securities. Remember that the companies that receive the loans that make up a CLO usually have relatively low credit ratings. Individual investors should be aware that they’ll likely be low on the list of creditors if the company can’t repay its debts in full.
Historically, CLO default rates have been fairly low. Of the 6,000-plus CLO securities Standard & Poor’s rated between 1990 and 2013, only 25 have defaulted, for a total default rate of 0.41 percent. But investors should still learn as much as they can about any CLO mutual fund they want to invest in. As any good financial advisor will tell you, past performance does not guarantee future results.
It’s also important to remember that mutual funds that invest in CLOs trade publicly, and are thus vulnerable to investor sentiment. That means that the fund’s share prices ebb and flow with demand. If investors get nervous about high-risk investments, share prices might drop suddenly and dramatically. Also worth noting: CLOs themselves can be rather illiquid investments, meaning that there may not always be a willing buyer at the exact moment an investor is ready to sell.