Collateralized loan obligations (CLOs) have been gaining wider prominence in markets in recent years, and it’s no surprise why – they have historically offered a combination of above-average yield and potential appreciation that is especially compelling in today’s low-yield environment. Yet while CLOs have historically yielded attractive performance versus other fixed income strategies, some investors may be intimidated by their complexity or shy away from them because of their similarity to other asset classes that performed poorly during the global financial crisis.
That said, US and European regulators have since taken steps to mitigate CLOs’ structural risks. This is one of the reasons why CLOs have historically remained attractive.
CLOs originated in the late 1980s as a way for banks to package leveraged loans together to provide investors with a vehicle with varied degrees of risk and return to best suit their investment objectives. The first vintage of “modern” CLOs – which focused on generating income via cash flows – was issued starting in the mid- to late-1990s. Commonly known as “CLO 1.0,” this vintage included some high yield bonds, as well as loans, and was the standard CLO structure until the financial crisis struck in 2008.
The next vintage, CLO 2.0, began in 2010 and changed in response to the financial crisis by strengthening credit support and shortening the period in which loan interest and proceeds could be reinvested into additional loans.
The current vintage, CLO 3.0, began in 2014 and aimed to further reduce risk by eliminating high yield bonds and adhering to the Volcker Rule and other new regulations. In 2020, the Volcker Rule was further amended, and high yield bonds are now allowed back into CLOs. Currently, few CLOs allow for investments into high yield, and those that do generally limit the exposure to 5%-10%. To compensate for the exposure to high yield, these CLOs have increased levels of subordination aimed to better protect debt tranches.
Vintages 2.0 and 3.0 represent the biggest chunk of the market, with about $800 billion in principal outstanding, while less than 1% of the market is CLO 1.0 vintages.1
Source: BofA Merrill Lynch Global Research. As of 30 June 2021.
While CLOs have undergone significant changes aimed to reduce risk for investors, they remain complex instruments that require a high degree of expertise. Because CLOs are issued and managed by asset managers, the most critical decision a CLO investor can make is the selection of a manager. It isn’t easy: There are approximately 175 managers2 with post-crisis CLOs to choose from, and each creates its own portfolios using its own investment style. And while historical performance varies greatly among managers, there are several key traits that successful managers share. Experience is the most important. There’s no substitute for deep CLO management experience, which provides the combination of skills, practice, tactical and strategic savvy, adjustment-making, and chronological perspective needed to generate strong returns in such a complicated asset class. The benefit of having managed portfolios before, during, and after the financial crisis is incalculable.
Managers should excel in the vital competencies that collectively define best-practice portfolio management. These include loan selection, trading prowess, effective management of deteriorating credits, and the reinvestment of principal proceeds in new collateral.
Finally, sound risk management is both a cause and effect of these best practices: It informs everything the manager does and is reflected in the results. In addition to oversight of the portfolio, it includes skillful execution of coverage tests, the ability to understand the nuances of CLO documentation, and a talent for balancing the numerous portfolio metrics.
To learn more about CLOs and their potential benefits in today’s market, read our full CLO primer, “Seeing Beyond the Complexity: An Introduction to Collateralized Loan Obligations.
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