Download CLOs, CDOs and the Search for High Yield

January 2014
CLOs, CDOs and the
Search for High Yield
Introduction
Against a sterile investment landscape, the hunt for alternative sources of yield has become hugely
challenging for pension trustees. There are however certain asset classes which are often overlooked by
pension schemes which, in certain forms, offer the potential to provide the strong, long term liability matching
cash flows highly coveted by pension schemes. One of these, although much maligned during the credit crisis,
is Structured Credit. Within this paper we examine the viability of two subsets of Structured Credit;
Collateralised Debt Obligations (CDOs) and Collateralised Loan Obligations (CLOs).
What exactly are CDOs and CLOs?
CDOs and CLOs are a form of Asset Backed Security (an investment linked to the returns and income
typically from a pool of other assets to diversify risk). In the case of a CLO the underlying assets are a pool of
bank loans and for a CDO, a pool of bonds and mortgages. Under a CLO or CDO the investor earns income
in the form of interest payments from these debt instruments and is otherwise subject to the gains and losses
on those loans over time as their prices change/and or if defaults occur. CLO/CDOs can also be sliced into
tranches and their entitlement to cash flows determined by their seniority ranking. Coupon payments vary by
tranche with the most senior holder paid the least and the most junior paid the most, to compensate for the
higher risk of default. The examples used within this article are taken from the US where the market for these
instruments is perhaps most prevalent.
What makes these type of vehicles potentially attractive right now?
First of all, credit market fundamentals in the corporate sector are currently very healthy.
We need no reminding that the UK government is forging ahead with its austerity measures in a bid to bring
the national debt under control. An inevitable side effect of these has been continued sluggish economic
growth as endured in many other developed countries such as the US and France.
By contrast, company balance sheets and cash flows tend to be strong. This is illustrated in the chart below
which shows that interest coverage (a measure of the company’s ability to service its debt) is currently at an
all time high.
Chart 1
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The strong fundamentals of the corporate market are also manifested in default rates which are low in
absolute terms and relative to historical averages. This can be seen in the chart below.
Chart 2
But what are the specific attractions of bank loans compared to other types of corporate loan?
Loans generally trade at significantly wider spreads and higher yields than comparably rated corporate debt.
The chart below shows that loans currently offer almost the same yield as high yield (sub-investment grade)
bonds (5.5%-6% p.a.), despite their senior ranking in the case of default.
Chart 3
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As illustrated in the following chart, they also generally have offered higher recovery rates in the case of a
default.
Chart 4
But what about liquidity – what happened over the financial crisis?
Liquidity certainly deteriorated over the financial crisis and this was reflected in the market price of CLOs.
However, actual defaults were minimal and price falls within the representative index in 2008 were fully
recouped in 2009, as illustrated in the chart below.
Chart 5
What are the risks?
A primary concern is of course that of default. Chart 2 on page 2 of this paper shows that this has risen to the
8% level twice in the past 15 years; first around the technology bubble and subsequent downturn, and more
latterly during the financial crisis of 2008-09. Note however the default has only momentarily reached this level
and the long run rate is less than 5%. Moreover chart 4, also shown on page 2, shows that even in default,
recoveries have averaged around the 70% level. Actual losses over the long term have therefore been quite
small.
Chart 2, however, also shows that at the same time the default rate has increased, so has the spread over
treasuries. This implies a meaningful capital loss on a mark to market basis. Liquidity has also tended to dry
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up in these conditions and the natural expectation is that this would be also the case in the future.
For this reason most providers have official ‘lock up’ periods and the risk is that these come into force during
periods of stress. This is also likely to coincide with a poor equity market environment.
In summary therefore, whilst CLOs and CDOs offer high yields with a relatively small risk of permanent capital
impairment, they could be included in a part of the overall portfolio which is not expected to offer instant
liquidity.
What role could these vehicles play in a pension portfolio?
CLO/CDO investments can be structured to deliver a range of target yields via creating tranches. A typical
range of expected returns p.a. could be 3%-10%. Investments at the low risk/return end of the spectrum share
the characteristics of liability matching assets, i.e. they can provide stable, medium/long term cash flows
whereas investments at the upper end of the risk/return spectrum can be considered potential return
enhancement or growth style assets. Overall, by holding a CLO an investor is exposed to the performance of
a portfolio of loans, receiving loan interest while being exposed to loan defaults. However, via tranching of a
CLO an investor can also choose to be exposed, for example to the first 10% of defaults on the underlying
loans (high risk) or only be impacted should defaults reach 11%-20% (low risk), or 21%-100% (very low risk).
In return for taking more/less risk an investor will receive a higher/lower income stream.
How can a pension fund access these vehicles?
Pension funds who feel that they possess the necessary internal expertise naturally have the option to
approach specialist providers in order to access CLO/CDO funds. As with all niche areas, the most
appropriate access point will depend on individual circumstances and appetite.
Where Pension schemes feel they may lack the requisite knowledge and expertise it may be sensible to talk
to an investment manager such as a fiduciary manager/delegated consultant or implemented consultant. A
fiduciary manager, such as SEI, may be able to provide specialised advice on an appropriate allocation from
your risk budget in addition to helping you identify the most suitable vehicle.
Conclusion
Trustees of pension schemes should recognise that CLO/CDO investments do not offer instant liquidity.
However as a long term investor a pension scheme can typically tolerate a level of illiquidity within the overall
investment portfolio that other investors cannot.
Despite exhibiting volatility in times of crisis CLO/CDO investments have generally delivered positive and
consistent long term returns. And with credit market fundamentals currently strong, historically low default
rates and high recovery rates, these investments compare well with other areas of the credit spectrum
especially in today’s low interest environment. Schemes looking to discover more about CLO/CDO
investments may benefit from engaging with an investment expert such as a fiduciary manager. As a fiduciary
manager with an extensive heritage in providing and implementing advice that links both assets and liabilities,
SEI is optimally positioned to guide pension trustees on the option for their schemes.
Contact us
For more information email us at [email protected] or telephone +44(0)20 7297 6408.
About SEI’s Institutional Group
SEI’s Institutional Group is one of the first and largest global providers of outsourced fiduciary management
investment services. The company began offering these services in 1992 and today acts as a fiduciary
manager to more than 450 retirements, non-profit and healthcare clients in seven different countries. Through
a flexible model designed to help our clients achieve financial goals, we provide asset allocation advice and
modelling, investment management, risk monitoring and stress testing, active liability-focused investing and
integrated goals-based reporting. For more information visit: http://www.seic.com/enUK/institutionalinvestors.htm.
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About SEI
SEI (NASDAQ:SEIC) is a leading global provider of investment processing, fund processing, and investment
management business outsourcing solutions that help corporations, financial institutions, financial advisors,
and ultra-high-net-worth families create and manage wealth. As of September 30, 2013, through its
subsidiaries and partnerships in which the company has a significant interest, SEI manages or administers
$529 billion in mutual fund and pooled or separately managed assets, including $219 billion in assets under
management and $310 billion in client assets under administration. For more information, visit www.seic.com.
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