Institutional investors, and the consultants seeking to protect them, naturally fear that the next financial bubble hides in plain sight.
While caution is justified in light of the traumatic events of 2008-'09, the seeming obsession that some pundits and policymakers have with characterizing America's $1.2 trillion leveraged loan market as a new trouble spot is unjustified and potentially harmful to our capital markets.
Many institutions continue to acquire exposure to the leveraged loan market through investments in collateralized loan obligations. They do so because CLOs offer the prospect of attractive yield over a long-term horizon of seven to 10 years.
Comparable in some ways to banks, CLOs are structured investment vehicles designed specifically to play an important role in our capital markets by lending to corporate borrowers. But, where banks fund themselves by taking deposits that may be short term, CLOs capitalize and lend by issuing long-dated and intermediate-term notes to institutional investors such as pension funds, insurance companies, foundations, and endowments. CLO managers are registered investment advisers and fall under the jurisdiction of the Securities and Exchange Commission, like any other investment adviser.
For investment committees trying to parse through the noise in today's marketplace, there are a number of reasons CLOs should remain attractive investments within well-diversified portfolios.
First, CLOs invest the majority of their capital in senior, secured loans made to a diverse group of corporate borrowers that include familiar names like Dell Technologies Inc., First Data Corp. and Hilton Worldwide Holdings Inc. While all loans bear risk, these loans hold the strongest claim on all of a borrower's assets in the event of a bankruptcy or default. This type of protection is particularly important as the volume of "covenant-light" loans continues to grow.
Another reason many institutions continue to invest in CLOs is the "layer cake" capital structure of these vehicles, which allows investors to allocate capital in direct proportion to their appetite for risk. CLOs raise capital by issuing notes that range from very low risk AAA-rated tranches, which are the most senior and enjoy the first claim against cash flows, all the way to higher-risk tranches. An investor with an appetite for higher risk exposure can achieve higher coupon payments through mezzanine and equity tranches.
It is also important to underscore that CLOs have processes and tests in place to help make sure that cash inflows from underlying loans can satisfy distributions to investors across tranches. The CLO manager actively selects and monitors loans in which the CLO invests, but that manager is constrained by limitations designed to maintain strong diversification and quality. These rules aim to preserve the structural integrity of the CLO and limit the risks to those investors at the bottom of the capital structure.
With all this context in mind, it is critical to put risk into perspective. The default rate on high-yield bonds, which are a very popular component of many mutual funds and retail offerings, reached 16% during the global financial crisis and remains near 4% today. In contrast, the default rate on leveraged loans peaked at just more than 8% during the crisis, and now stands at less than 2%.
As institutional investors continue to evaluate CLO investment opportunities, it is essential to look past misleading headlines and focus on realities. Focus also should be placed on evaluating the outlook for the leveraged loan market.
The credit risk that exists in the market is manageable. In fact, non-investment-grade borrowers' debt servicing ability remains strong, and there is no evidence that companies are anywhere close to being unable to repay or service obligations. Even Federal Reserve Chairman Jerome Powell echoed this sentiment this year when he told Congress the leveraged loan market is not systemically risky.
In sum, institutions should have confidence in the underlying strength of the CLO industry as new issuances emerge. A review of objective data and facts shows CLO managers are well-regulated and guided by robust processes and tests to help them navigate the natural credit risks in the market.
Lee Shaiman is the New York-based executive director of the Loan Syndications and Trading Association, which advocates for the corporate loan market. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.
