After eight years of Creditflux columns, Thomas Majewski looks back at the factors that have most impacted CLO returns

Reflecting on the past eight years, the market faced no shortage of macro twists and turns. Despite large swings in interest rates, regional bank turmoil, dramatic shifts in Washington, wars and even a pandemic, CLOs ultimately did exactly what I expected them to do — deliver strong and consistent cashflows to investors.

While countless hours are often spent debating a single basis point on a triple A or marginal MVOC differences between two similar CLO securities, the reality is you had to try hard to lose money investing in CLOs over the past eight years. Even for the limited number of double Bs that won’t return full capital, many will still have a handsomely positive IRR once many years of coupons are factored in.

I’m frequently asked about risks in CLOs. The most common themes I’m probed on include the always upcoming increase in loan defaults, covenant-lite loan structures and the impact of rising interest rates. A few now ask about LMEs, which create a sort of stealth default rate.

The first bout, in my view, was driven by regulatory requirements for risk retention. Many billions of dollars of capital were raised by CLO collateral managers from unaffiliated third-party investors so that CLO collateral managers could satisfy the regulations. (I’m sure the framers of the risk retention rules weren’t contemplating that teachers’ pension funds would be the risk retention party in CLOs, but that’s a discussion for another time.)

While the regulations were ultimately made inapplicable by courts, at least for BSL CLOs, in early 2018 the short-term damage was done. These large pools of capital — raised under the auspices of “solving a regulatory problem” — proved to be terrible for the loan market as many (but not all) CLO collateral managers with captive funds bought perhaps USD 100bn of loans, massively distorting demand in the loan market and supply in triple As.

While a small number of issuers used these captive structures well, I believe they were in the minority. For many, they became analogous to unsponsored private equity investing.

While equity investors worked hard to reset and refinance their CLOs during these periods of compression, it was nearly impossible to keep pace with the torrent of loan repricings. The bench of CLO bankers that could effectuate equity-driven resets and refis simply wasn’t deep enough. We’re happy to welcome Japanese and Canadian banks into the underwriter market, deepening the bench.

Through our intimate knowledge of CLO collateral manager performance, it has become abundantly clear that while some can generate real alpha within a CLO structure (where interest income counts differently than principal), few, if any, can outperform the loan index on an unlevered basis net of fees. Loans earn about 350 over the benchmark rate, and CLO collateral managers often take more than 10% of that spread as a base fee. For an asset class largely capped at par, it’s a very, very high bar to even match the index net of fees.

When it comes to LMEs, of the roughly 100 over the past several years, we think more than half were non-pro-rata, meaning lenders were not treated equally. We’re continuing to study this and see predictable trends forming. Indeed, fighting to be in the winning group in a non-pro-rata LME is a new skill CLO collateral managers must perfect.

Finally, let’s not lose sight of CLOs’ broader role: fuelling economic growth. Indeed, over the past eight years, the US CLO market has grown at roughly double the pace of the US economy. While we obsess over basis points as fiduciaries for our clients, at the core, this market helps power the US economy while generating superior returns for our investors. A true win-win.