CLOs emerge from CDO shadows

The sentiment towards most asset classes took a hammering during the financial crisis, none more than structured finance. But, according to one of the largest managers in this space, if you looked at the details many investments performed well. Babson Capital, which is either the largest or second-largest manager of CLOs (collateralised loan obligations) in the world – depending on your measurement period – believed that the financial crisis had actually proved that these sorts of instruments did, and do, what they promised. Matt Natcharian, managing director and head of structured credit for Babson, admitted that CLOs had been tarnished by the reputations of their less-secure cousins, such as collateralised debt obligations (CDOs) and the general sub-prime mortgage mess. “But bank loans aren’t subprime mortgages and CLOs are not CDOs,” he said.

“The re-emergence of the primary market confirms our belief that CLOs are here to stay.” As at the end of last year Babson Capital and competitor Carlyle both had about US$21 billion under management in CLOs – the two largest such managers in the world. Both firms oversee deals globally, mainly in the US and Europe. According to research by Babson, the financial crisis did not result in any cases of the senior cashflow CLOs incurring any principal losses. Most junior tranches, which did suffer in the meltdown, were currently trading at 70-85 per cent of their pre-crisis levels. More than 80 per cent of the CLO equity tranches were cashflow positive. “Ratings agencies are currently upgrading CLO tranches, not downgrading them,” Natcharian said.

“The credit performance of the underlying collateral – syndicated bank loans – was both predictable and transparent. Default and recovery rates were consistent with previous recessions and have quickly returned to pre-crisis levels. Secondary market liquidity allowed for normal market operation and price discovery.” A remaining issue for CLOs with some super funds was their complexity. There were multiple tranches for investment – senior debt, mezzanine debt and equity – with different risk/return characteristics. The yield for senior investment-grade credit was between 3-6 per cent; for mezzanine it was 5.75-11.0 per cent; and for equity it was 10-15 per cent.