Conceptually, overcollateralization tests require that the amount of senior secured loans held in the underlying collateral pool of a CLO has to exceed the amount promised to investors who purchase the debt tranches of the CLO by a certain percentage. Why does this matter? The levels of excess collateral in current CLOs would allow them to withstand the default and recovery experience of past credit cycles. For additional perspective, stress tests of a recent CLO showed that generating a principal loss in the BB tranche would require a constant default rate of 4.44 percent (assuming a 40 percent recovery rate) over the span of 8.5 years.
If any overcollateralization or interest coverage tests fail, the CLO diverts interest and principal due to junior tranches to pay down senior tranches (or, purchase more collateral in certain cases) until such time that the covenants are back in compliance. These protections improve the resiliency of the more senior CLO debt tranches to default experience.
Revised Rating Agency Methodologies And Enhanced Regulatory Environment
Despite its strong history, the asset class wasn’t immune from the sweeping regulatory changes and rating agency methodology revisions following the wake of 2008. This means the CLO market has become stronger from these important dimensions.
New U.S. regulations imposed after the financial crisis reduced reliance on leveraged investors in the CLO market and influenced an improved risk profile via Volker Rule provisions. Real money investors such as pension funds, asset managers and insurance companies, especially those from Asia, are larger holders of the asset class. Stable long-term investors represent a significant portion of CLO market participants.
This Risk In CLOs is Idiosyncratic, NOT Systemic
Despite improved regulatory framework, and the sector’s proven track record, CLOs aren’t for everybody. CLOs are compelling for buy and hold investors like insurance companies that have emerged as a significant presence in the CLO market. In addition, for multi-sector fixed income strategies with the appropriate structural and credit expertise, CLOs can diversify a broader fixed income portfolio. However, in the context of multi-sector portfolios, CLOs can experience periods of pricing volatility in secondary markets. We witnessed this in December 2018 and CLOs have been slower to retrace spread widening relative to other risk markets.
It is also important for investors to understand that risk across the asset class isn’t uniform—bad actors do exist and, like in any market, so does risk and so does reward. That said, as an asset class, we view the risk in CLOs as idiosyncratic and believe the systemic, fear mongering doomsday scenarios are ultimately exaggerated.
Dave Goodson is head of securitized at Voya Investment Management. Mohamed Basma, CFA, is senior vice president and portfolio manager at Voya Investment Management.