It has been 10 years since the financial crisis and many pundits are using this arbitrary anniversary to prognosticate the next great financial calamity. Collateralized loan obligations (CLOs) have taken their turn in the spotlight, cast as the villain most likely to bring the global economic system to its knees.
Make no mistake, risk is elevated—particularly for the broader corporate credit arena. Central banks responded to the global financial crisis by providing unprecedented amounts of liquidity, which fueled debt market growth and investor risk taking. Recent credit expansion has been in non-traditional categories, including senior loans, the underlying collateral of CLOs. However, gaining a comprehensive view of risk in this environment requires a deep understanding of the different instruments used to gain corporate credit exposure. As headlines and fear mongering reverberate around doomsday scenarios caused by CLOs, panic is not the proper course of action. Why? Because we think the following insights can help efficiently navigate the path ahead.
Proven Track Record: CLOs Tested ‘Through-The-Cycle’ Performance
It is important to understand that CLOs are not some new flashy product; they have been around since the late 1980s.
Since inception, AAA- and AA-rated CLO tranches never experienced a default or loss of principal, even during the depths of the financial crisis. Lower-rated tranches of CLOs have only experienced minimal long-term impairment rates over this same time period, faring much better than other corporate credit sectors of the same credit quality.
Collateral: CLOs Provide Exposure To A Senior-Secured Asset Class
Senior loans, the underlying collateral of CLOs, are a large part of the reason why CLOs have delivered a track record of low impairment rates. Senior loans hold the highest rank in a borrower’s capital structure, making them less risky. In the event of a borrower’s bankruptcy, or other liquidation scenario, senior loan obligations would be paid first, ahead of loans or liabilities. Furthermore, senior loans contain contractual provisions, or covenants, that impose limits on what the borrower may do with the borrowed money.
It is important for investors to remember that despite the senior secured status of loans, the asset class still represents lending to companies that are below investment grade. Like other below investment grade allocations, nothing is guaranteed and issuer selection based on rigorous fundamental research is critical, especially in the latter stages of a credit cycle. For example, attention to detail in covenant packages is of particular importance in today’s lending environment.
Covenant packages, when measured overall in the asset class, have deteriorated in terms of their quality in recent years. While the implications are uneven across issuers, this is an enhanced risk for investors to chart course around when investing in CLOs.
In addition to the senior-secured status of their underlying collateral, CLOs have embedded structural protections provided by a cash diversion mechanism of the CLOs. This mechanism is governed by overcollateralization (OC) and interest coverage (IC) tests, and is triggered if there is meaningful deterioration in collateral performance from levels set at inception of the CLO.