Income Investing: European CLOs
24 July 2017
Benoit Pellegrini, partner of Chenavari, the portfolio manager of Toro Limited, explains the make-up and benefits of collateralised loan obligations (CLOs), the vehicles in which bank loans can be securitised.
One year on from the Brexit vote and the UK’s political landscape is less certain following the inconclusive June elections. The last twelve months have generally shown political risk receding across Europe: the large victory of the centrist pro European candidate Emmanuel Macron in France’s presidential elections, populist parties stumbling in the latest Italian elections, and the failure of nationalist parties to lead governments in The Netherlands and Austria.
Unlike US data, which have been disappointing lately, European Economic data also show accelerating growth, with May composite PMIs remaining elevated and eurozone GDP growing 0.6% in the first quarter of the year. Hand in hand with improving economies is improved credit fundamentals: declining default rates, improving corporate profitability and M&A activity.
One way of capitalising on these improving fundamentals is by lending to European companies via senior secured bank loans, which we believe are a good source of alternative income.
The borrower risk is mitigated by the loans being secured against the company’s assets and ranking ahead of other debt obligations in the event of a default. They also pay a floating rate of interest, which is appealing in an environment where interest rates are likely to rise. European senior secured bank loans have also shown greater stability during recent volatile periods than US loans, as indicated in the chart below.
Source: S&P Global. ELLI corresponds to the European loan index while the LLI is US
On the back of a brightening political and macroeconomics outlooks, European leverage loan issuance has nearly doubled in the first half or 2017 compared with the same period last year with €58 billion of issuance (Source: LCD European weekly, June 30 2017).
One of the most efficient ways of investing in a diverse portfolio of senior secured bank loans for both institutional and retail investors is via collateralised loan obligations (“CLOs”). CLOs are the vehicles in which bank loans can be securitised. The borrowers tend to be medium-to-large companies for which extensive financial information is available. To attract buyers and lower the cost of financing, a CLO is split into tranches which are rated (from AAA down to B rating) by multiple rating agencies and issued as floating rate notes with a fixed spread. Both loans and the financing of these CLOs are floating rate and currencies are matched.
Every quarter, the CLO is paid income from the loan portfolio: it pays the interest due on the financing and expenses and then pays any remaining cash (its funding margin) to investors in its income notes. The income note return is primarily a function of the manager’s ability to avoid poorly performing loans in the portfolio, although CLOs historically include 100 loans from different companies, so the risk concentration is not as high as if an investor took the direct route and invested in fewer loans.
CLO income notes can potentially offer investors attractive double-digit returns: from 10% to 20% depending on the CLO and investment vehicle. The average dividend yield for the London and European listed closed-end funds invested in CLOs was over 9.56% for 2016 on an annualised basis (Source: Bloomberg). This excludes any further return through NAV or share price appreciation. By way of comparison, the FTSE All Share dividend yield was 3.47% for 2016 (Source: Bloomberg).
One of the reasons that these returns are relatively attractive is that market inefficiencies create income opportunities for investors. Liquidity, for example, may be perceived to be overpriced and many investors have been investing through the bond markets to gain exposure to corporate credit. This has pushed the potential returns offered by bonds down and, comparably, loans and CLOs can offer much more compelling risk-adjusted returns, given they have security over assets. CLOs also have the added benefit of diversifying the investment risk across a portfolio of loans. If the default risk of an industry increases or there are signs that a company may struggle to service its debts, the manager of the CLO can substitute such loans for those of safer companies.
During the 2008 financial crisis, many structured finance vehicles gained a bad reputation and CLOs were often confused with CDOs (collateralised debt obligations). In fact, the loans underpinning CLOs performed strongly throughout the credit crisis and beyond. One of the biggest risks for a CLO is that the loans in the CLO default. During the financial crisis, the highest average default rate over five years was 3.53% p.a. between 2008 and 2012 (Source: Credit Suisse Institutional Leveraged Loan Default Review, 2013). This strong performance has continued and the last 12 month default rate for the S&P loan index was 2.2% as of June 2017 (Source: Bloomberg).
Structured finance vehicles have, however, received more attention from regulators. Regulators around the world realised that the parties originating loans that would be securitised could pass on the entire investment risk of those loans to the investors in the securitisation. This meant loan originators may have been more focused on the quantity of transactions rather than the quality of the underlying portfolios. This potential misalignment of interests between loan originators and securitisation investors has now been addressed in the EU by rules requiring originators to keep a stake in the performance of the loans, commonly referred to as risk retention requirement. In return for using their capital to retain this risk, investors in listed vehicles acting as originators of loans can receive higher returns relative to direct investment in structured credit investments securities, such as CLO income notes.
The average investor is still relatively unaware of the potential returns available through investing in the leveraged loan market either directly or through CLOs. As the possibility of an unwinding of the ECB’s quantitative easing programme and rising interest rates approaches, we believe this is surely an investment opportunity that should be more widely considered.
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