Investor demand for Collateralised Loan Obligations (CLOs), which bundle and sell corporate debt to investors, will pick up in 2021, says Loomis Sayles Fixed Income Group Portfolio Manager John Bell.
“Until there’s that big long-term default wave event that kills returns at the bottom end, CLOs will do pretty well,’’ he says.
“They’ve been battle-tested. They ‘re getting it right. It could be years before CLOs will come under this pressure again.”
Bell says the market performed well in 2020, and did better than during the Global Financial Crisis (GFC) because defaults were minimised by faster responses to the Pandemic by central banks while speaking at Investment Magazine’s Fixed Income and Credit Forum in late March.
He says CLOs, essentially a ten-times-levered bank loan portfolio, had 61 per cent of its investors in B and 21 per cent in BB-grade loans.
The reason investors “lean” on these grades were because they need BB to “make their arbitrage work all the way up and down the capital structure”, he says.
Investors wanting to earn 12-15 per cent will get that spread from going down in quality to Bs, he says.
“When the pandemic started and the market was theoretically discounting 12-15 per cent default rates, the two (B) tranches plummeted in price because of the potential of a long default wave,’’ Bell says.
“In the GFC those tranches went to nearly zero in a more extended downturn where defaults picked up a lot. You didn’t get that this time so why not?
“It took a while for the Fed to come into the GFC; it took a lot less time for the Fed to show up in this crisis.
“After that fiscal policy, people started to feel better. The retail funds that were selling and they were the ones were driving the prices down. When that was over, CLO tranches worked their way back over the course of the year,’’ he says.
Despite floating rates and low or light covenants, the higher quality CLO tranches of AAA and AA have never been in default and ‘below that, default rates have been lower than corporates at the same level,’’ Bell says.
Investors looking for higher returns are turning to non-investment grade debt, which is often fed by loans to smaller companies and attracted lower investment grades because ratings agencies disfavoured smaller and newer companies, Bell says.
Bell does not consider a drop in quality of the investment tranches as a risk going forward.
“At Loomis, we have conservative and aggressive strategies. We’ve looked at every loan that’s been made in past 20 years,’’ Bell says.
“We don’t see loans getting worse. It’s really the same. The thing that drives CLOs is a model created by the rating agencies in the way they perceive the world and certain amounts of risk.
“A lot of those companies are technology companies creating those B2s … ,I don’t see how you can get inflation in CLO tranches or some misunderstanding, it’s a lot more cookie cutter than you think.”
He says CLOs have been through three bad events – the 2001 recession, GFC and Pandemic without defaults in the AAA or AA tranches and few defaults in the bottom tranches.
“We see a lot of demand for them in 2021,’’ he says.
