CLOs – The Quest for Yield

Guest Post by Expert Robert Bozza

As we enter the summer months of 2014, following a five year bull market in equities, the quest by professional investment managers and individual investors for yield and returns continues as equity indices remain at near-all-time highs, and US Treasury yields, credit spreads and volatility (as measured by the CBOE VIX index) are at pre-crisis lows (see Table below). Investment risks are also increasing as investors take on additional forms of leverage, structural complexity and credit risk while giving up liquidity.

Source:  Bloomberg, Moody's Analytics, BarCap Live, S&P Capital IQ, Citi Investment Research

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This quest for yield and returns is clearly highlighted by the significant volumes being originated in the Collateralized Loan Obligations (“CLO”) Market, a market once thought dead post-financial crisis, which is now surpassing volumes not seen since 2006/2007 (forecast of up to $100 billion of issuance for this year, which would surpass the $97 billion peak sold in 2006). CLOs  are structured investment vehicles which hold below-investment grade bank loans (though senior secured) and are constructed in much the same way as CDOs, in that the underlying are pooled together and then tranched in accordance with investor appetites for risk, return, and credit quality (for more detail see our White Paper on CDOs). 

A recent article in the Wall Street Journal noted that hedge funds and other institutional investors are now able to borrow up to $9 dollars for every $1 dollar of collateral to purchase the AAA-rated tranches of various CLOs.  Further, the article states “Hedge funds have finally come to grips with leverage and begun to embrace it" for CLOs, according to Jean de Lavalette, head of securitized products sales at Société Générale.  Hedge funds are interested in borrowing funds to buy securities because the leverage involved helps them boost returns to investors.  Banks and Brokerages are willing to finance these purchases because it lends support to distribution and future CLO deal origination, and investors require it.    

Why should there be concern with hedge funds investing in AAA rated CLO securities, and the near record CLO deal volumes, when defaults on the loans collateralizing CLOs have been historically very low and the new structures (CLOs 2.0) post-financial crisis have more structural subordination along with other enhancements?   There a few reasons for caution:

• US Treasury yields, credit spreads and volatility are at pre-crisis lows. 
• While the hedge fund investments noted in the WSJ article are rated AAA, the addition of leverage, structural complexity inherent in these securities, and low absolute yields (3M LIBOR plus approximately 150 basis points for a total yield of 1.75% at current market levels) collectively increases the mark-to-market risk of these investments should volatility increase, credit fundamentals decline, and/or credit spreads widen (refer to Table for historical perspective). Further, in April of this year, the Federal Deposit Insurance Corp. asked lenders to designate AAA rated portions of the notes as “higher-risk” assets.    
• New forms of leverage may be indicative of returns that are insufficient to meet investors' objectives or goals and/or complacency about the risk of the underlying collateral and securities being financed.
• While the primary investors in CLOs are sophisticated institutional investors (foreign banks, mutual funds, registered investment advisors and hedge funds), the money they’re investing in CLOs is on behalf of both individuals and institutions (pension funds, not-for-profits, corporations, etc.).   These individuals and institutions are willing to give up liquidity (lockup periods with hedge funds can be up to two years with quarterly redemptions) and pay investment management fees (ranging from .25% to 3% of assets annually) in order to achieve higher returns to meet their investment goals and objectives in this low-return environment.    

In conclusion, the quest for yield and returns will likely continue until volatility increases from these historically low levels – but warning signals are emerging, issued by regulators and notable investment managers around the world.  In fact, the CLO marketplace itself could soon be changing, as a result of regulatory requirements brought on by Dodd-Frank (Section 941).  The Federal Reserve has already granted the banks a two-year exemption in meeting the Volcker Rule requirements in relation to CLOs, after the industry protested that implementation of the new rules would lead to heavy losses.  The rule would require that CLOs be treated the same as other asset-backed securities (like MBS), meaning that originators would have to retain a 5% interest in each issue.  A similar rule in Europe (Article 122a of the EU Capital Requirements Directive) has largely squeezed European banks out of the CLO market.