By Hamlin Lovell, NordicInvestor
Positive Yield Oasis amid Negative Yields
“Structured credit offers a yield pickup of between 100 and 400 basis points for a similar type of risk, as measured by credit ratings. Whereas many investment grade corporate bonds have now moved into negative yield territory, CLO liabilities are priced off a floor of zero. This means that in the AAA category, CLO’s paying 90bps floored offer a pickup of 185bps compared to investment grade bonds that now has a yield to worst of minus 95bps.”, says Sandro Naef, co-founder, CEO, Partner, and Portfolio Manager of Capital Four.
“Covered bonds and Danish mortgages can also have a negative OAS spreads”, he adds. Capital Four observes that the CLOs backed by mortgages tend to offer somewhat lower yields than corporate ones.
“On a relative basis, AAA and BB lower mezzanine tranches of corporate CLOs are particularly attractive relative to other asset classes. CLO equity has some interesting optionality but needs to match investors’ liquidity profile and requires a long term holding period; it is not something to trade on a daily or weekly basis. We are also very careful in selecting CLO equity because defaults may pick up late in the cycle”, he points out.
“The zero floor will become even more attractive if the ECB cuts rates further”, expects Naef.
On an absolute basis, CLOs offer some degree of value: spreads per turn of leverage remain above the pre-crisis lows, while recent default rates have been towards the lower end of the range.
The majority of European CLO assets are actually managed by US-headquartered managers, who often also run US CLOs. The US CLOs naturally yield more in US Dollars, but there is not much difference, on average, after accounting for interest rate differentials and hedging costs. However, there are differences at the top and bottom of the CLO waterfall. “Senior tranche spreads are wider in Europe, while junior spreads are wider in the US. Higher US spreads should be seen in the context of structural differences: there is more leverage in US deals, which are also more diversified because the universe of loans is larger in the US”, says Naef. Capital markets in the US play a bigger role in financing companies relative to banks than is the case in Europe.
“Historical default rates have been lower on CLOs than on corporate bonds with equivalent ratings. For instance, AAA rated CLOs in Europe have never defaulted, even during the great financial crisis”, he recalls.
Thus, the yield premium on structured credit is not only a premium for credit risk. It is usually characterized as an illiquidity and/or complexity premium.
As far as liquidity is concerned, the CLO market has grown over the years. CLO liabilities of c EUR 100 billion are now roughly half the size of the European leveraged loans market of c EUR 200 billion. But CLOs are still not the most liquid credit sub-asset class.
As far as complexity is concerned, that is what Capital Four’s 44 investment professionals get paid to understand. The firm has a structured, multi-stage investment process with daily, weekly, monthly and quarterly meetings. ESG is incorporated into the investment process, and CLOs consider ESG risk factors including companies that get more that 50% of revenues from activities including: oil, gas or thermal coal extraction; thermal coal power generation; controversial weapon end products or inputs; hazardous chemicals; pornography or prostitution; tobacco or related products; predatory or payday lending.
A slow-moving market
So far 2019 has seen CLO liabilities and their collateral constituents – leveraged loans – moving in opposite directions in terms of spreads, expanding the “CLO arbitrage”. This is due to an imbalance between supply and demand. CLO issuance has been accelerating while senior loan issuance has slowed down. The disconnect between CLO and loan spreads is not entirely unusual however. Structured credit is less liquid, and tends to follow moves in liquid credit with a time lag. “For instance, high yield bonds and loans started recovering in 2009, but structured credit did not follow suit again until 2010. And again in 2012, it was liquid names that fell first, foreshadowing declines in structured credit a year or two later. If history repeats itself, structured credit should start appreciating over the next two quarters”, says Naef.
Capital Four is issuing a European corporate CLO in October or November. Capital Four’s investor base extends well beyond its home market of Europe with a diversified and developing client base South America and Asia. The investor groups for the CLO are expected to be mainly institutions in Europe– including wealth platforms, pensions, insurance, foundations and family offices – and some of Capital Four’s own funds.
Other Capital Four funds have the ability to allocate to the equity of the CLO (and not the liabilities). In these cases, the fees on the CLO equity are fully waived, so that fees are only charged at one level – the top level. This fee “rebate” can considerably boost returns. Given that CLO equity is 10 times leveraged, its 0.5% management fee is equivalent to 5% on the whole structure, and hence the rebate could add as much as 5% to annualized returns. This could increase target returns from 12% to 17%, gross of fees.
Capital Four runs EUR 2.4 billion in leveraged loans, and has a track record of outperforming the index by an annualized 2.62% since 2012, with much lower volatility and drawdowns than most peers in the eVestment CLO manager database. There have been no defaults at all in the loan strategy while European and US loan markets have on average seen annual losses of just over 1% from defaults over this period.
The firm’s high yield bond strategy has also outperformed its benchmark, by a somewhat smaller amount, and incurred average annual default losses of just 0.27% since 2001, versus 1.05% for European high yield and 1.71% for US high yield. The firm is very selective when ramping up its CLO portfolios, and might only invest in 20% of the relevant universe, which is mainly senior secured loans.
The firm’s portfolio managers have an average of 18 years’ experience, and Capital Four’s Credit Opportunities fund has been investing in, and generating strong returns from, CLOs since 2010. The firm has good access to primary issuance in the loans market, which is important for deploying capital.
In total Capital Four runs c EUR 12 billion and the managers “eat their own cooking”: 1% of assets belong to Capital Four employees.