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Opinion CLOs
For many CLO managers, the flight to safety is driven by fear of LMEs
by Thomas Majewski
Thomas Majewski
Founder & managing partner
Eagle Point Credit Management
Without active management, safe CLO portfolios will limit returns
The CLO market is witnessing a shift towards purportedly ‘safer’ portfolios in new issue CLOs. But market sentiment has led many CLO collateral managers to perhaps unduly minimise risk over prudently maximising returns. This raises important questions about the true nature of risk management and the potential for underperformance of many new CLO equity tranches being issued today.
It is essential to understand whether safer portfolios serve the best interests of investors, or if they are simply the path of least resistance for CLO collateral managers looking to justify underperformance. In our view, only those CLO collateral managers that continue to prioritise active portfolio management (read: trading), while also prudently managing risk, will produce superior risk-adjusted returns over the long term.
The current state of the new issue CLO market presents a paradox. While CLO liabilities have become attractive, with the all-in cost of capital approaching SOFR plus 175bps, the arbitrage remains well below recent levels. While mid-130s triple As feel reasonably attractive compared to last year’s levels, CLO debt spreads are only part of the CLO equity equation. Loan spreads have compressed significantly and many new issue single B loans are now coming at the very low 300s, reflecting a net tightening of the arbitrage. Exacerbating the problem, loan convexity is largely gone, with most loans trading at or around par.
Taking advantage of trading opportunities
Many CLO collateral managers are marketing to investors on the merits of safer collateral pools — touting their optionality, downside protection and the value of locking in non mark-to-market CLO financing for future collateral opportunities — as a justification for issuing against the challenging initial arbitrage. There is some merit to this.
However, many CLO collateral managers don’t have the DNA to effectively and actively rotate their portfolios on ‘risk-off’ days in the market. Frankly, some have a bad habit of trimming risk (read: selling loans at losses) on risk-off days. Therefore, it is incumbent on investors to discover if CLO collateral managers have the skills to take advantage of trading opportunities when the market presents them.
Though we believe CLO equity remains attractive for CLO collateral managers focused on maximising long-term equity returns, we caution investors to be wary of many common pitches.
For CLO collateral managers, the flight to safety is driven by the fear of liability management exercises (LMEs). LMEs have fundamentally altered the investing landscape for all loan investors, principally to the benefit of sponsors. The potential for aggressive sponsors to push CLO collateral managers to take losses in order to stave off new-money threats is creating a strong incentive for CLO collateral managers to avoid situations they might otherwise have believed they were likely to work out without default. But LMEs are becoming a permanent part of loan investing, making complete avoidance nearly impossible. A safer portfolio without active management won’t save you from LMEs; it instead limits your return cushion when one arises.
It is important to be certain that CLO collateral managers are resisting unfair LMEs for amend-and-extend or refinancing possibilities. This includes pricing in prior bad acts by offending sponsors on new loans the next time these sponsors come to the market to borrow.
Resisting the lure of big bond buckets
As CLO collateral managers seek to create portfolios with any meaningful amount of discount, we have seen CLO collateral managers liberally utilising high yield bond buckets. Bonds add convexity due to rate duration in an environment where rates are falling and discount opportunities are scarce, but many employing this approach don’t fully appreciate that interest income is far more valuable in a CLO structure than principal gains.
In a CLO with a heavy bond bucket, the CLO equity is almost certain to underperform on current cashflow in hopes that rates decline swiftly and the CLO collateral manager can capture a pull towards par, before rotating back into loans with higher interest rates. This is a pretty significant rate bet, and one we don’t think is likely to be fruitful.
While attempted avoidance of LMEs through safer investing choices is understandable, it is not without its pitfalls. True value in CLO equity investing comes not from blindly pursuing ‘safe’ strategies, but from CLO collateral managers who aren’t afraid to actively manage their portfolios, turning over positions when opportunities to capture value present themselves.