Breaking Down the CLO Market
Established through a special purpose vehicle (“SPV”), a CLO is a securitized pool of diversified leveraged loans across issuers and industries predominately rated single B and BB, with the SPV issuing multiple tranches of debt to finance the acquisition of the loans. As shown in Figures 1 and 2, the assets are generally 1st lien senior secured loans to issuers across several industries, including Healthcare & Pharmaceuticals, High Tech, and Business Services. The issued tranches include rated debt and unrated equity which provide a range of risk and reward profiles, making them potentially suitable to a wide set of investors predominately across banks, insurance companies, asset managers, pensions, and endowments.
The most prominent sub-sectors in the CLO market include deals backed by the following types of colateral:
- US Loans: US broadly syndicated leveraged loans, primarily 1st lien senior secured.
- European Loans: European broadly syndicated leveraged loans, primarily 1st lien senior secured.
- Middle Market Loans: US 1st lien senior secured direct private loans to small and medium sized companies, typically with earnings before interest, taxes, depreciation, and amortization (EBITDA) of less than $100mm.
- Infrastructure Loans: 1st lien senior secured loans comprised of project finance loans and broadly syndicated loans to corporate borrowers within infrastructure sectors.
A relatively new entrant to the structured products sector, the CLO market began in 1990, growing slowly at first, but doubling in size over the last five years as institutional investors gravitated toward the market for its unique diversification benefits. As of the end of 2021, the asset class had matured to $1 trillion. Further, the market has a strong presence on both sides of the Atlantic. The global market is 83% USD CLOs and 17% EUR CLOs.2 Select CLO managers focus on the middle market sub-sector which represents ~10% of the US CLO universe.2 In 2021, the US CLO asset class experienced record issuance volume with $187bn issued across 127 active managers in the US.2
Performance tracking with total returns and analytics began in 2014 with the inception of the J.P. Morgan CLO Index (“J.P. Morgan CLOIE”) and in 2016 the Palmer Square CLO Index, which increased market awareness and use of a benchmark for performance and target allocations.
Credit Performance
CLO historical loss experience, coupled with ratings resilience through the great financial crisis and COVID-19 pandemic, has demonstrated robust performance through tail risk events.
In 2020, the downgrade percentage of issuers within the leveraged loan universe reached 47%, the majority of which occurred in March and April. However, using the J.P. Morgan CLOIE index to give a perspective on the US CLO rating transitions, only 2% of US CLO bonds by volume and 9% by count were downgraded. 95% of those downgrades were primarily concentrated in Single-B, and BB-rated tranches and to a lesser extent BBB-rated tranches.3 Globally, rating agencies continue to unwind pandemic driven downgrades and positive rating migration in loans has been improving CLO collateral profiles leading to CLO upgrades in subordinated tranches. Approximately 54% of CLO tranches downgraded in 2020 have since been upgraded or had its rating withdrawn as a result of paydowns, refinancings and resets.4
Structural protections have generally led to lower CLO tranche principal loss due to embedded credit enhancement, covenants, and portfolio quality criteria. Performance demonstrates low levels of principal loss based on historical impairment rates. Data on Moody’s rated CLOs from 1993- 2020 show an impairment rate of 0.6%, with no principal losses reaching AA and AAA rated bonds.
The key structural protections in CLOs are (1) credit enhancement in the form of subordination and (2) excess spread which together can absorb collateral losses before they impact bonds (Figure 7). As a result of these structural features, AAA-rated CLO tranches with 35% credit enhancement can withstand a 38% constant annual default rate (CDR) before incurring a first dollar of principal loss (Figure 8).
Several structural features of CLOs aim to help provide protection to investors in more senior tranches during times of stress, especially to investors in the senior parts of the CLO capital structure:
- The CLO structure penalizes excess holdings of loans rated Caa1/CCC+ or below
- Collateral Quality Tests (CQTs) restrict a manager’s ability to trade and add more risk to the portfolio
- Coverage tests ensure tranche interest and principal bond payments. If there is collateral deterioration, equity distributions are redirected to buy additional collateral to bolster the structure.
These structural features taken together are designed to help senior tranches to withstand significant collateral.
Relative Value
CLOs may offer compelling relative value against similarly rated floating rate asset classes across varying tenors and rating levels in the primary and secondary markets. Structurally, a typical AAA new issue has a 2-year non-call and a 5-year reinvestment period (5-6 Year Weighted Average Life (WAL)) along with a coupon of SOFR + 180 basis points.
CLO AAAs may provide attractive value as a short-term alternative. As shown in Figure 9, short AAA-rated CLOs (1-3 Year WAL) offer a spread of 100-130 basis points. Shorter duration tranches can offer value versus similar WAL/rating alternatives within securitized products. CLOs have consistently offered 60-100 basis points of excess spread compensation to traditional, AAA-rated structured finance investments as a result of their structural nuances and underwriting complexity, highlighted by their callability and negotiated governing documents.5
Liquidity
As the CLO sector continues to mature, trade volume reported by TRACE illustrates healthy liquidity in the asset class across many different risk environments. One way to measure liquidity is to refer to the trailing 24-month average of monthly trading volume which is ~$13.1bn. During the highly volatile COVID-19 pandemic, monthly trade volume peaked at $27.5bn in April 2020.6 CLO trading volumes in 2021 totaled $142bn, which is the 2nd highest year following the record of $187bn reached in 2020, with 2022 trending above both. AAAs comprise the largest portion of traded volume given that AAAs often represent over 60% of the deal structure. During times of market stress, the top of the capital stack tends to have greater volumes as investors look to sell higher dollar price assets to generate liquidity. Using the J.P. Morgan CLOIE as a proxy for outstanding market size, average trade volume as a percent of the market has kept pace with a growing market.
Investment Considerations
Dedicated CLO managers, with strict investment guidelines, actively manage the collateral pool through purchases and sales during the reinvestment period. CLO managers typically trade based on their fundamental outlook on the loan portfolio and industry exposures. We believe that a good manager will have a strong track record, disciplined credit process, and substantial infrastructure to support the investment process.
We expect investors to continue increasing their allocation to this asset class considering its historical performance through cycles, scalability, and relatively high spread compared to other fixed income alternatives.
We believe CLO investors must underwrite portfolios, structures, and managers to uncover investment opportunities. MIM has been investing in CLOs for over 20 years, with investments across the US Broadly Syndicated Loan, European Loan, Middle Market Loan and Infrastructure Loan CLO sub-sectors. The asset class has been embedded into our fixed income portfolios since its inception.
We summarize the key potential benefits and investment considerations below:
Benefits
- Diversification — CLOs enhance portfolio diversification given their relatively low historical correlation with most major asset classes. The low correlation is largely attributed to their floating rate structure. Investors with allocations to investment-grade credit and U.S. corporates may benefit by diversifying into CLOs.
- Structural Protections — CLO debt tranches have credit enhancement features in the form of par subordination and excess spread. Further protections are provided through underlying portfolio concentration limitations, collateral tests, and cashflow redirection from equity to debt tranches in periods of stress.
- Income — Total return is primarily from coupon income, which can increase to the extent that underlying interest rates rise since spreads are linked to a LIBOR/SOFR benchmark.
- Risk Profile: Performance demonstrates low levels of principal loss based on historical impairment rates.
Investment Considerations
- Interest Rate Risk — CLOs are a low duration product due to their floating rate nature. In general, coupons fall (negative) when rates fall and rise (positive) when rates rise.• Callability — CLOs are structured with non-call periods that typically last two years. After the non-call period, CLO managers and equity tranche holders have the option to refinance debt tranches at a lower spread, as market conditions and spread levels permit.
- Credit Risk — Below investment grade debt obligations are regarded as predominately speculative with respect to the borrower’s continuing ability to meet principal and interest payments. Lower quality debt obligations may be more susceptible to real or perceived adverse economic and individual corporate developments than would investment grade debt obligations.
- LIBOR to SOFR Transition — The primary market for U.S. CLOs and leveraged loans has made a nearly seamless transition into SOFR-based pricing. The majority of legacy deals still have LIBOR-based pricing, but most have been amended with language to address the transition to a new benchmark reference rate.
Endnotes
¹ MetLife Investment Management, KANERAI, Intex, as of 5/27/2022.
2 Source: MetLife Investment Management, KANERAI, Intex, as of 5/31/2022.
3 Source: J.P. Morgan CLOIE Rating Transitions, January 29,2021.
4 MetLife Investment Management, Barclays, and Bloomberg.
5 MetLife Investment Management.
6 MetLife Investment Management, FINRA TRACE
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