Are CLOs Right For Your Portfolio?

During 2023, the Credit Suisse Leveraged Loan Total Return Index (CSLLI) was up 13.0% on a total return basis–according to Bloomberg.  This was during a banking crisis, when commercial real estate office buildings were under pressure, and interest rate uncertainty weighed heavy on investors’ collective minds.

At the end of 2023, 85% of the loans in the CSLLI traded above 95 cents on the dollar–compared to roughly 60% at the end of Q4 2022*. That would indicate that leveraged loans are getting closer to ‘priced-to-perfection,’ which would make any contrarian investor nervous, and is worth noting.

Due Diligence and Monitoring is Essential

Managers of Collateralized Loan Obligation (“CLO”) are indicating higher defaults in 2024. which could negatively impact investors’ returns–especially with less credit-worthy CLO funds or if an underlying manager has not been sufficiently researched. Sticking to investment-grade CLOs is likely to benefit investors in the long-term–given the cash-flow stream underlying the CLOs. Capital that is less likely to be downgraded enhances the tactical ability of the CLO to take advantage of market dislocations and deploy capital to buy debt at more attractive prices. However, we have seen CLO managers call capital and deploy money into market pull-backs during the run-up seen in the CSLLI described above.

The knee-jerk reaction might be to withdraw or underweight fixed income in anticipation of a pull-back in the public markets due to rising or flat interest rates, instead of the downward direction of interest rates anticipated by the markets since Q1 2023. We believe the CLO structure is an attractive vehicle for maintaining both upside exposure and downside exposure–but like all investments, due diligence and monitoring is essential.

Manager Selection Plays a Key Role

CLOs are structured investment vehicles that use syndicated debt capital, in addition to equity capital, to purchase a pool of loans as the underlying collateral. Initially, the target underlying collateral is purchased through warehouse financing provided to the CLO issuer. Then, debt capital in tranches, ranging from the most senior then down, is issued. Additionally, equity capital is provided by the CLO issuer. These are used to pay off the warehouse financing.

CLO debt investors are paid down by the principal and interest payments from the underlying loans. CLO equity investors are paid the spread between the income earned by the CLO and the debt service paid by the CLO to its debt holders. While CLO debt holders sit higher in the capital structure and are less likely to see ‘defaults’ by the CLO itself, there are still credit risks to the CLOs that can make an AAA-rated CLO tranche more risky or less risky, depending on the portfolio of loans the CLO has invested in. This is where manager selection plays a key role.

About the CSLLI

The CSLLI tracks the investable markets of the U.S. dollar-denominated leveraged loan market. It consists of issues rated “5B” or lower, meaning that the highest-rated issues included in this index are Moody’s S&P ratings of Baa1/BB+ or Ba1/BBB+. All loans are funded term loans with a tenure of at least one year and are made by issuers domiciled in developed countries. (Source: Morningstar)

*Sources: Canyon Capital Advisors, RJA, Intex, Markit

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