Alt credit

From barbell to bucket

The many ways to leverage collateralized loan obligation equity across a portfolio

The case for considering an investment in collateralised loan obligation (CLO) equity tranches is multi-faceted.

In our earlier piece, The case for CLO equity, we highlighted a number of its potential attractions, including its outperformance against other high-yielding assets classes over the past decade and the possible positive response over the mid-term to a rising credit spread environment. In addition, there is the potential for high front-loaded cash flows and moderate duration. But, it is also worth looking at exactly how CLO equity tranches can be included in a portfolio, as investors have several options when deciding on how to position exposure.

From barbell to bucket

Allocation, could reside within the investor’s credit opportunities bucket, making it more of a risk-budgeting decision than a part of the asset allocation process. Given the level of expected return, CLO equity exposure could also be positioned in a growth portfolio e.g. with the aim of helping to close funding gaps.

For some institutional investors, a barbell strategy can be of interest. The most frequent example consists of replacing a 100% high-yield portfolio with a barbell approach i.e. 75% investment grade bonds and 25% CLO equity tranches.

This barbell approach could possibly enjoy an improved risk-return profile as illustrated in the table below. In addition, in the event of an uptick in high-yield spreads which investors could consider excessive, in regard to underlying risks, a barbell portfolio would also allow them to reallocate some investment grade to high-yield securities – and therefore further increase the potential return of the portfolio.

CLO equity exposure can improve the risk-return profile of a credit portfolio

Source: AXA IM. For illustrative purposes only. This is not a reliable indicator of current or future performance. Based on prospective analysis over an eight-year horizon considering initial market conditions of mid-Dec 2017 and a market event similar to the 2015-2016 US High Yield crisis: for HY, an initial spread of 3.6% and a 1.68% default per year with 40% recovery; for IG, an initial spread of 1% and no default; for CLO equity tranches, an IRR before default of 17.5% and 12% post default; a drawdown at end of year four of -13% for HY, -4% for IG and -16% on CLO equity tranches; a 250 bps increase in high yield spread captured at high yield repositioning2

 

The risks involved with CLO equity

These risks include the subordination of cash flows to CLO debt tranches, the leveraged exposure as well as the risks associated with the underlying loans. In addition, investors need to consider low liquidity, performance risks and undefined maturity.

  • Low liquidity:

The frequency of trading of a CLO equity tranche is irregular – some tranches have never traded during their life. However this does not mean that these instruments are illiquid. Broker dealers, due to the very high level of transparency on CLOs, would typically offer a bid/ask spread of close to 1% in normal market conditions and up to 5% during market turbulence[3].

  • Performance risks:

Although CLO tranches are traded in non-regulated markets, they are extremely transparent financial instruments in the sense that trustee reports publish the full list of the CLO’s holdings every month, which allows investors to estimate the fair value of any equity tranche available in the market at any time. Investors can also rely on independent cash flow forecasts and valuation estimates from industry providers[4] that integrate observable and public measures on the most recent trades of CLO tranches, loans and other credit asset classes. Valuations can also be quite volatile – especially in the face of a dislocation of the underlying loan market. Investors need to allow for a potential drawdown of typically 30% to 40% for this asset class.

  • Undefined maturity

The maturity of the equity tranche and that of the CLO structure usually range from six to nine years, though the final maturity is undefined at launch. The termination of the overall structure is usually decided by the CLO equity tranche holders in conjunction with the CLO manager and in accordance with their ability to continue making the underlying loan pool profitable to the CLO equity position.

It is also worth noting the wide performance gap between the top and bottom performing CLO managers. Looking at 2003 to 2011, the average difference in CLO equity internal rate of return (or IRR) between the top 80th and the bottom 20th percentiles was 12.5%[5]. As a result, a specialist portfolio manager who has the ability to pool CLO equity tranches is worth considering  because they should be able to select  CLO managers by properly assessing their credit  research capabilities and their experience in handling various credit situations.

[1] A -40% instead of -16% drawdown on the CLO equity tranches would be required to align drawdowns of allocations A & B.

[2] Sources: Bank of America Merrill Lynch US Corp Master and Bank of America Merrill Lynch US High Yield (spreads of mid-Dec 2017 and drawdown in 2015-2016); Standard and Poor’s (default rates over 2015-2016: global corporate AAA-BBB, average global B and BB); Wells Fargo Securities - The US CLO Equity Performance Report.

[3] Source: AXA IM based on market experience

[4] E.g.: JP Morgan Direct, Markit, etc

[5] 17 Data on terminated Broadly Syndicated Loans CLOs. Source: Intex, Wells Fargo Securities as of Q2 2017.

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