CLO Mezz and Equity

Jeffrey Bakalar

Jeffrey Bakalar

Group Head and Chief Investment Officer, Leveraged Credit Group

Mohamed Basma

Mohamed Basma, CFA

Managing Director, Head of Senior Loans and Global CLOs

Tamara Wieging

Tamara Wieging

Vice President, Client Portfolio Manager

An attractive entry point for long-term investors

Executive Summary

  • CLO structure has been tested through two major market crises: While CLOs have experienced intermittent periods of volatility, the asset class has ultimately experienced fewer defaults than corporate bonds of the same rating—this resilience combined with the potential for upside returns makes the asset class compelling for long-term minded investors:
    • Historical impairment rates of 3.0% and 5.9% for BBB and BB rated U.S. CLO tranches compared to 3.4% and 15.3% for U.S. BBB and BB rated U.S. Corporates (Cumulative impairments over period of 1993-2018, Source: Barclays)
    • Over the last ten years, the impairment rates are even more compelling: 1.2% and 3.9% for BBB and BB rated U.S. CLO tranches, respectively (Source: Citi Research, Moody’s as of 12/31/2019)
  • CLO Mezzanine tranches offer attractive absolute and relative value: In a world where yield is extremely scarce, CLO Mezzanine tranches appear attractive on both a spread and an absolute basis versus other corporate credit sectors like high yield
  • CLO Equity offers exposure to potential upside as recovery continues: Robust new CLO formation, an improving macro and credit environment, and tighter CLO liabilities provide a supportive backdrop for CLO equity
  • Voya’s current outlook and positioning: Between the opportunity to purchase cleaner, less COVID-impacted new issue paper, and the potential for acquiring mispriced securities in the secondary market, we believe CLO mezzanine and equity tranches provide one of the most compelling and diverse opportunity sets today given the scarcity of yield across most other segments of the market
    • Our medium-term allocation bias is anchored on newer vintage CLOs (2018 onwards), longer dated reinvestment periods (3-5 years), conservative/defensive managers, and clean portfolios that exhibit minimal tail risk and manageable exposure to issuers/sectors directly impacted by COVID-19

The CLO Structure Endures: Cycle Tested Performance

Due to both increased issuance in the U.S. and Europe and a robust secondary market, CLOs have become an established asset class, allowing investors to make investment decisions based on their views of the economy, sector, manager, and credit cycle.

Having endured two major market crises, CLOs have displayed better default and recovery statistics than similar asset classes. 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 (Figure 1). Senior loans have unique structural features, namely that they are secured by a borrower’s assets pursuant to a first priority or “senior” lien. In the event of a borrower’s bankruptcy, or other liquidation scenario, senior loan obligations would be paid first, ahead of other unsecured or subordinated debt or liabilities.

Figure 1. CLO Structure: Built for Strength
Figure 1. CLO Structure: Built for Strength

Source: Voya Investment Management. For illustrative purposes only.

In addition to the senior-secured status of their underlying collateral, CLOs have imbedded 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. Conceptually, overcollateralization tests require that the principal value of senior secured loans held in the underlying collateral pool of a CLO exceeds the principal value of the issued debt tranches of the CLO. Similarly, interest coverage tests require that the income generated by the underlying pool of loans be greater than the interest due on the outstanding debt in the CLO. If any OC or IC tests are failing, the CLO waterfall 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.

While higher rated CLO tranches are the primary beneficiaries of IC and OC tests, these structural protections support the entirety of a CLO, as they force managers to improve the underlying collateral risk through challenging market conditions and serve as guard rails to deals, keeping them from serving only the interest of one side of the stack over the other. Accordingly, there is a net benefit to mezz and equity investors as the IC and OC tests are a meaningful construct as it relates to the stability of the asset class.

Indeed, the performance of mezzanine CLO debt and CLO equity during volatile market environments has confirmed the resilience of the underlying senior loan collateral and the CLO structure. As Figure 2 highlights, CLO mezz and equity tranches have recovered and generated full year positive returns in 2020, despite the volatility in the early part of the year. We believe the asset class is also well positioned for the road ahead.

Figure 2. CLOs Tested “Through-the-Cycle” Performance
Figure 2. CLOs Tested “Through-the-Cycle” Performance

Source: Citi Research, Bloomberg, LCD as of 1/12/2021.

CLO Mezz: Attractive Absolute and Relative Value in a Low Yield World

Against a backdrop of extremely low yields across most areas of the debt markets, CLO mezzanine tranches offer compelling absolute and relative value versus other similarly rated sectors such as high yield bonds (Figure 3). While IG CLO tranches have largely retraced their pre-pandemic spread levels, junior mezzanine tranches continue to grind tighter, but remain relatively wide in secondary markets, reflecting investor caution in credit selection of tranches that display a wide dispersion of underlying loan assets, manager performance, and structures.

Figure 3. CLO Spreads and Yield versus Other Corporate Credit
Figure 3. CLO Spreads and Yield versus Other Corporate Credit

As of 06/04/21. Source: Voya Investment Management and Citi. LH chart represents stated nominal spread over LIBOR.

CLO Equity: Attractive Exposure to Potential Upside as Recovery Continues

Recall that economically, the CLO equity investor owns the underlying managed pool of senior loans and the CLO debt investors finance that same pool of loans. CLO equity does not have a set coupon. Instead, the equity tranche represents a claim on all excess cash flows once the obligations for each debt tranche have been met. Accordingly, the performance of the CLO equity tranche is heavily tied to the strength and performance of the underlying senior loan collateral.

Going forward, we believe the most material downside risks in the senior loan market have diminished considerably, as the upward trend in corporate earnings is largely expected to continue against the backdrop of strong GDP growth in the near term. Market participants are also focused on inflation and rate volatility, both of which have been recently ignited by prospects of additional government spending. Should there be a further leg up in longer-end rates, we expect loans to benefit in such a scenario given the inherent rising-rate protection offered by the asset class.

In addition to capitalizing on opportunities in the secondary market, CLO equity investors can also participate in new deals. In 2021, CLO issuance is projected to increase to more than $100 bn, compared to the 2020 revised forecast of $90bn, offering ample opportunity to participate in attractive new deals. New issue CLOs are likely to be much cleaner than older vintages due to screening of any heavily affected COVID issuers. They would also be a direct beneficiary of new issue loans coming to market with moderately tightening though still attractive spreads, the benefit of LIBOR floors in many cases, and typically a lower Weighted Average Rating Factor1 (WARF) than older vintages, which may still be sorting through the downgrade activity of 2020.

Understanding and Managing CLO Risk

CLO structures are undeniably complex. For example, CLOs with identical underlying collateral assets may produce varied performance due to differences in their structure. Additionally, legal documentation governing a typical CLO often exceeds 300 pages. However, despite this structural and legal complexity, at the end of the day CLOs are simply a collection of legally-bound claims on the cash flow generated by a pool of senior loans. This means that risk, i.e. how much you can potentially lose, is quantifiable, which allows investors to look ahead and stress test CLOs through different default scenarios.

To illustrate this point and help demonstrate the current risk profile of CLO equity (the “riskiest” tranche of a CLO), we conducted cash flow analysis on new issue CLOs, using a variety of vintages and managers to form a representative sample set for the CLO 2.0 index2. As Figure 4 highlights, for equity investors in these CLOs to experience a negative return, annual senior loan default rates would have to average ~5% for 10 consecutive years (assuming a 75% recovery rate). For context, the 10-year and 20-year average default rate for senior loans is 1.88% and 2.67%, respectively. Meanwhile, the lagging 12-month default rate (by issuer and principal), is also well below 5%.

Figure 4. There Would Have to Be a Significant and Persistent Spike in Defaults for Long-Term CLO Equity Investors to Experience a Negative Return
Figure 4. There Would Have to Be a Significant and Persistent Spike in Defaults for Long-Term CLO Equity Investors to Experience a Negative Return

As of 05/30/21. Source: Voya Investment and S&P/LCD, S&P/LSTA Leveraged Loan Index. Lagging 12-month default rate comprises all loans, including those not tracked in the LPC mark-to-market service. Vast majority are institutional tranches. Issuer default rate is calculated as the number of defaults over the last twelve months divided by the number of issuers in the Index at the beginning of the twelve-month period. Principal default rate is calculated as the amount defaulted over the last twelve months divided by the amount outstanding at the beginning of the twelve-month period.

Note: Default rate assumptions in left hand chart are based on the cash flow analysis of representative new issue CLOs using annual prepayments rates of 25% and underlying loan recovery rates of 75%. Past performance may not be indicative of future results.

Importantly, the risk analysis in Figure 4 is in the context of a full CLO lifecycle, i.e. it assumes an investor will buy and hold the CLO tranche. There can certainly be periods of volatility, as we witnessed in 2020.

In addition, it is important to remember that risk across CLOs is not uniform. CLOs are actively managed vehicles, i.e., they have a reinvestment period during which the manager can reposition the portfolio within the parameters set forth by the governing documents. Managers can add value by reinvesting and repositioning portfolios to increase returns in benign economic environments and protect against downside risk during weaker economic times. Even though CLO managers tend to add value, the variability in their performance, especially during periods of distress, is significant (Figure 5). Therefore, in addition to analyzing collateral and structure, it is important to analyze manager’s credit expertise and investment style, and to select managers with a proven record of improving the risk/return profile, building par and loss mitigation, and maintaining stable collateral metrics/equity distributions over multiple credit cycles.

Figure 5. Dispersion in Performance and Default Among CLO Managers
Figure 5. Dispersion in Performance and Default Among CLO Managers

Source: Credit Suisse, The CDO Strategist October 27, 2011. Cash-on-cash return is calculated by quarterly cash flows to the equity tranche divided by the outstanding balance of equity tranche; all returns are annualized. Statistics based on average of top and bottom 5 managers among managers with more than 5 CLOs in management.

Conclusion: Voya’s View and Current Positioning

Investors can access CLO mezz and equity tranches by participating in new deals or via transactions in the secondary market. Between the opportunity to purchase cleaner, less COVID-impacted new issue paper, and the potential for acquiring mispriced securities in the secondary market, we believe CLO mezzanine and equity tranches provide one of the most compelling and diverse opportunity sets today given the scarcity of yield across most other segments of the market.

In the medium term, our allocation bias is anchored on newer vintage CLOs (2018 onwards), longer dated reinvestment periods (3-5 years), conservative/defensive managers, clean portfolios that exhibit minimal tail risk and manageable exposure to issuers/sectors directly impacted by COVID-19.

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1 The weighted average rating factor (WARF) is a measure that is used by credit rating companies to indicate the credit quality of a portfolio.
2 The first vintage of modern CLOs was issued starting in the mid-to-late 1990s. Commonly known as “CLO 1.0,” this vintage included some high yield bonds, as well as loans, and were the standard CLO structure until the financial crisis struck in 2008. The next vintage, “CLO 2.0”, began in 2010 and changed in response to the crisis by strengthening credit support and shortening the period in which loan interest and proceeds could be reinvested into additional loans.

Past performance does not guarantee future results. This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities.