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Chasing Yield in a Shady Market
Plus May Market Report

John Gorlow | Jun 11, 2019

Ticking time bomb.” “Marginal, non-creditworthy borrowers.” “Vulnerable to runs.” “Huge deterioration in standards.” You may have been reading the press about Collateralized Loan Obligations (CLOs) over the past few months or year. They are not a new product, but warnings about their risks are on the rise. Are you tempted to invest in these high-yield securities? If so, learn more before jumping in. Our analysis follows a review of May markets.


May Market Report

World Asset Classes

It was a difficult month for stocks, topped by broad market turmoil. Rising trade tensions sent stock and bond yields skidding around the world. As a barometer, the MSCI All Country World Index gave back -5.93% for the month after rallying 15.96% for the first four months of the year. International developed markets were the top performers, followed by the US and emerging markets, respectively. US crude prices slumped into a bear market. Gold shined as traders fled risky assets. The IMF warned that the US-China tariff politics could knock 0.5% off global growth, putting particular pressure on emerging markets. At the same time, US-China trade negotiations appeared to be moving closer to some kind of resolution. Yields on ten-year government bonds dropped through 2.1%, accelerating a year-long decline. The Federal Reserve hinted at interest rate cuts to cope with trade wars.

US Stocks

US equities as measured by the S&P 500 Index returned negative -6.35%, bringing year-to-date returns to 10.74%.  For the one-year period, returns on the index from April to May dropped from 13.49% to 3.78%.  Small caps underperformed large caps. Value stocks underperformed growth stocks marketwide.

International Developed Stocks

Developed markets outside the US as measured by the MSCI World-Ex USA Index returned negative -4.73%, outperforming both US and emerging markets. Year-to-date returns on the index finished the period at a positive 8.21%. Small caps underperformed large caps. Value underperformed growth across both large and small cap categories.

Emerging Markets Stocks

Emerging markets as measured by the MSCI Emerging Market Index returned negative -7.26%, bringing year-to-date returns to positive 4.09%. Small caps underperformed large caps and emerging market value stocks outperformed emerging market growth stocks.

Real Estate Investment Trusts (REITs)

Real Estate securities were relatively unscathed. US REITs and international REITs returned negative -0.34% and negative -0.64%, respectively. Year the date, US REITs returned 15.11%, making them the top performing asset class among the major categories.

Fixed Income

The 10-year U.S. Treasury Bond closed the month at 2.13%, down from last month's 2.50%. Oil decreased to close at $53.36 from last month's $63.38. Gold was up, closing at $1,310.20 from last month's $1,282.70. Bitcoin closed at $8,534 from last month’s $5,337. Barclay’s US Government Bond Index returned 2.33%. Treasury inflation protected securities (TIPS) gained 1.65%. Barclay’s municipal bond index returned positive 1.38%. Barclay’s US High Yield Corporate Bond Index gave back -1.19% leaving year to date returns on the index at 7.49%. The Federal Open Market Committee (FOMC) met and left its interest rates unchanged (2.25% - 2.5%), noting weaker than expected inflation.

Feature Article

CLOs: Is it Different This Time?

Remember the era of easy-to-get mortgage loans? Just about anyone with a pulse could be approved for a loan in short order. Banks were then able to pool, package and sell these loans as investment securities called Collateralized Debt Obligations (CDOs). CDOs created abundant wealth until the market collapsed and the party abruptly ended. Then they proved impossible to untangle and evaluate. Hedge funds, banks, Wall Street investment houses, borrowers and investors of every stripe were burned. Few escaped the carnage. 

It required a near collapse of the international financial system to teach some tough-love lessons about the economic risks embedded in lax, aggressive lending practices. But those lessons have been largely ignored. Post-collapse, calls for tighter regulation included a Dodd-Frank reform that would have required lenders to retain a 5% stake in loans originated and distributed for the purpose of being packaged as securities for investors. Legal challenges watered down this rule. Additional guidance issued in 2013 would have required banks to avoid loans that would make a company’s debts exceed six times ebitda. But guidance is just that; it has no teeth.  

Now flash back to 2008. As Main Street banks began to mop up the mortgage mess, Wall Street hedge funds, investment houses and other non-bank lenders stepped in to fill the void. They began creating new products to fund leveraged buyouts or refinance debt, pay special dividends to private equity investors, and lend capital to smaller companies. Enter the Collateralized Loan Obligation (CLO), a financial instrument created in the 1980s, and the ultimate owner of risky debt. You could think of the CLO as the quieter sibling of the CMO. The apple doesn’t fall far from the tree in this case.

What’s the appeal of CLOs? High yield. While the federal funds rate hovers between 2.25% and 2.5%, yields on leveraged CLOs can reach 8% to 10% for the highest quality tranches. That’s quite a premium. But a closer look reveals an extraordinarily complex financial instrument with hidden risks. Let’s begin with an explanation of how CLOs work.

A CLO Primer

CLOs are actively managed investment vehicles that invest in diversified bundles of commercial bank loans (collateral) that are backed by principal and interest cash flows from the loans. These commercial bank loans generally are highly leveraged and of poor quality.

To create their products, CLO managers use investor equity plus heavy amounts of borrowed capital to acquire a levered basket of risky loans. The cash-flows from the loans are packaged into tranches with varying degrees of risk, then sold to yield-hungry investors willing to put up equity capital in exchange for the promise of above-average returns.

Low risk-tolerant investors at the top of the CLO structure are tempted by the promise of those aforementioned 8% to 10% returns with a AAA rating. Investors at the bottom of the structure are hoping for much higher returns linked to the net profits of the CLO.

CLO managers profit by earning the difference that exists between excess spreads on the cash flows from their levered loan portfolios and their lower cost of capital. Many are able to rake in profits similar to hedge fund managers. They profit first by taking standard asset-based fees based on the face value of their loan portfolios, and second, by claiming performance-based fees of up to 20% of the CLO’s net profits (that is, 20% above a threshold rate of return promised to investors in riskier tranches). 

Complex, Opaque and Risky

Despite their appeal, CLOs expose investors to significant risks, including liquidity, default, counter-party non-performance, and legal and regulatory provisions that could adversely affect the leveraged finance marketplace.

But the biggest concern is what’s hidden inside these complex, opaque financial instruments. Because leveraged bank loans are legally defined as private transactions between lenders and borrowers, CLOs are unregulated by the SEC. As such, they are difficult to track, monitor and evaluate. They can be bought, sold, traded, repackaged and traded again. CLOs operate in a shadowy, murky marketplace. Most are typically organized in lightly regulated offshore havens like the Cayman and Channel Islands. No one can be sure how many intermediaries are involved, what discretion managers and lenders have to work the books to satisfy collateralization requirements, how often a CLO is repackaged and resold, or whether the loans are being leveraged in extreme ways.

Another Risk: Skyrocketing Growth

Fueled by more than a decade of very low interest rates, the global CLO market has soared to $1.4 trillion, a figure as large as the sub-prime mortgage market in 2006. And the market continues to grow.

S&P revised its forecast upward to a record $130 billion of new CLO issuance in 2019 alone. Seventy-five percent of the buying market is US based, with buyers including pension funds, insurance companies and banks (these institutions tend to focus on the safer tranches). The Bank of England reports that more than half of all leveraged loans in America is now bundled into CLOs. CLO issuance in European markets grew by 40% in 2018, and Japanese banks have become huge buyers.

Wealth managers and their accredited clients are jumping on the CLO bandwagon, and so are retail brokers and their clients, many of whom are beguiled by the promise of a unique, exclusive product that promises high returns. Robin Wigglesworth of the Financial Times reports that 90 leveraged bank loan funds existed on the eve of the financial crisis. Today that number has grown to 272 different loan mutual funds and an additional eight ETFs that buy these risky loans (data from Alliance Bernstein).

The impact of CLO money across the business world is evident. The ratio of business debt (excluding financial debt) to GDP is at a record high. High business debt is not a concern as long as companies are able to service those debts. But according to analysis by Carmen Reinhart, author of This Time It’s Different, of $9.6 trillion of (non-financial) corporate debt, roughly “$1 trillion … is accounted for by firms with debts greater than four times ebitda and interest bills that eat up at least half of their pre-tax earnings.” More troubling, Reinhart reports that the risky pool of leveraged debt “has grown faster than the rest, roughly trebling in size since 2012. All told, such debts are now roughly the same size as subprime mortgage debt was in 2007, both in absolute terms and as a share of the broader market in which it sits.” Leveraged loans, Reinhart notes, now rival junk bonds for market size. 

The fact that the riskiest and least transparent form of corporate debt has skyrocketed has stirred concern among finance leaders as well. “Someone’s going to get hurt here,” warned JP Morgan Chase’s Jamie Dimon last January. Just a few days ago, BofA’s CEO Brian Moynihan observed that “It’ll be ugly for those companies if the economy slows down and they can’t carry the debt and then restructure it, and then the usual carnage goes on.” That’s interesting, because according to Bloomberg, BofA is the largest leveraged-loan book runner. “We don’t see anything yet because the economy’s good, the companies are making money. The issue that’s there is in the leveraged future,” he said.

Others are less equivocal. Reinhart, who has studied many financial boom-and-bust cycles, notes that “A recurring pattern across time and place is that the seeds of financial crises are sown during good times (when bad loans are made) .... The record shows that capital-inflow surges often end badly. Any number of factors can shift the cycle from boom to bust.”

Former Fed Chair Janet Yellen, current Fed Chair Jerome Powell and a host of international bankers, regulators and policymakers have added their voices to the chorus of warnings. We’ll look at what could cause the CLO market to implode, and at the possible consequences. But first let’s give CLO defenders a chance to share why their product is safe.

In Defense of CLOs

It is true that CLOs fared better than the highly leveraged mortgage loans (CMOs) in the 2008 financial crisis, with none of the highest-ranking tranches defaulting. On the other hand, that was more than a decade ago, and before explosive growth in this market began eroding loan quality.

Earlier this year, Barclay’s published its own take on CLO facts, encouraging investors to follow these facts rather than “relying on media rhetoric.” It’s noteworthy that in May, Barclays brought in several new executives to beef up its CLO business. We quote key points from Barclay’s defense:

  • CLOs are not like other CDOs. Per Moody’s, the 10-year cumulative impairment rate of Global CLO tranches originally-rated AAA is 0.0%, while for global CDOs (ex-CLOs) it is 43.0%.

  • CDO lessons learned. From the CDO-era, we learned to avoid mark-to-market vehicles, to know the underlying assets, minimize correlations and understand the buyer base.

  • CLO structures have evolved. Post-crisis CLO deals tend to have less structural leverage, shorter reinvestment periods, more restrictions on asset holdings and greater focus on matching asset cash flows to liabilities.

  • CLOs are not forced sellers. CLOs are non mark-to-market vehicles that are incentivized to hold assets over the long term, rather than be forced to sell at the lows.

A Bloomberg op-ed by Satyajit Das reminds readers that "financial markets have short memories.” Das writes that “Underwriters have convinced themselves that CLOs are much safer instruments than the collateralized debt obligations, or CDOs, on which they’re based and which helped precipitate the 2008 crisis.”

A Bloomberg op-ed by Satyajit Das reminds readers that "financial markets have short memories.” Das writes that “Underwriters have convinced themselves that CLOs are much safer instruments than the collateralized debt obligations, or CDOs, on which they’re based and which helped precipitate the 2008 crisis.”

In fact, there are many similarities, Das points out. Both CLOs and CDOs are pools of multiple loans bound together to create “synthetic, bond-like investments.” Both are sold in tranches of varying risk. Both are designed to increase leverage on a portfolio of debt. Even so, Das agrees that CLOs are “set up to be safer,” because they are not invested in subprime mortgages but generally in a combination of leveraged corporate loans and consumer credit loans. Plus, investors in the better tranches have better protections than anyone had in CDOs.

Das points to other risks which we’ve discussed elsewhere in this article: credit quality is poor, borrowers are highly leveraged, and as the CLO market matures and expands, investors have fewer safeguards and protections. Minor losses could trigger big slides and hurt many more investors (including mutual funds) than the industry would have you believe.

Deteriorating Standards

It would be nice to peel back the covers to view the underlying assets and intertwined risks of CLOs and overleveraged bank loans. But the CLO market is a shadow banking system and information is scarce. One thing is certain: loan quality has worsened as the market for CLOs has boomed.

A large majority of new loans—between 80% and 85%—are now “covenant light” according to Moody’s and other sources. Yield-hungry investors do not seem concerned about this lack of creditor protection. If they did ask questions or dug deeper, they might discover some unpleasant facts.  

It’s no secret that borrowers are juicing their pro-forma financial statements to adjust earnings and reflect cost-savings that have not occurred, thereby inflating a company’s attractiveness to bank and non-bank lenders. Jonathan Lavine of Bain Capital compared these “add-backs” to “A 5-foot-8 man telling people he was 6-foot-2 on a pro forma basis,” adding “I can make adjustments like standing on a box, maybe trying to stretch.” Robert Smith, reporting for the Financial Times, calls this the financial equivalent of doping in sports. Everyone does it. CLO money makes it that much easier. “An already junky market has deteriorated further,” writes Robin Wigglesworth, with two-thirds of the market carrying a credit rating of B2 or worse.

Alliance Bernstein adds detail to this ugly portrait in a report noting that over half of loan issuers have “no unsecured debt to cushion their balance sheets.” Another unsettling fact is that these bank loans are used for so many leveraged buyouts in which default risk is extremely high. “When those defaults happen, recovery rates are likely to be a lot lower (on the bank loans) than in the past,” the report warns.

Add in the aforementioned lack of regulatory oversight and you’ve got all the elements of a potential catastrophe for CLO holders when the market turns and prices tumble. What will these complex loans be worth? Many investors do not fully understand the risks, the declining quality of the loans, and the fact that they are unshielded from major losses. “The networks for financial contagion, should things turn ugly, are already in place,” says Carl Reinhart.

Here’s how a cascade of trouble could begin:

Growth slows. This is already happening as the effects of the tax stimulus are wearing off. Slower growth means lower earnings with no reduction in overleveraged debt repayments.

Interest rates rise. The markets heaved a sigh of relief last week when Jerome Powell suggested the Fed would act to sustain the economic expansion in the face of escalating trade wars (read: lower interest rates). But at some point interest rates must rise, increasing the burden of debt on overleveraged companies.  

Substantial losses spread worldwide. As investors run for the exits, losses would quickly spiral out of control due to the massive amount of unsecured debt. Moody’s warns of first-lien recoveries of 61 cents on the dollar (compared to a historical average of 77 cents), and 14 cents on the dollar for second-lien loans (compared to a historical average of 43 cents).

Our Advice: Think Twice About CLOs

When it comes to leveraged debt, you—the investor—are the capital structure. Leveraged structures are used to fund leveraged deals by managers buying on leverage. That’s a lot of leverage, and nearly all of it is hidden. How can you know your CLO investment capital isn’t being used to pay off other investors, in the style of Bernie Madoff and Allen Stanford? You can’t. But what you can understand is that strong worldwide demand has created lax lending to non-creditworthy firms. Quality has deteriorated. Seniority as a lien-holder may not offer much protection. When the economic expansion falters, CLO noteholders are likely to be left holding the bag. There are many ways to take credit risk. Attractive as high yields might be, I would think twice before investing in the CLO market.

Do you have questions or concerns? Call me. I am here to help.



John Gorlow
Cardiff Park Advisors
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