The 2008 crisis was a natural point of reference to 2020. Both crises were characterised by a sudden market plunge, swift and large government interventions, and economic uncertainty. The two scenarios were different, however, and produced different economic outcomes, some of them unexpected. The fate of collateralised loan obligations, or CLOs, is a good example of how many commentators misread the potential outcomes of the pandemic in light of 2008.
In 2020, many began painting doom-laden pictures of an impending CLO crash. In the summer, for example, The Atlantic wrote that “the US financial system could be on the cusp of calamity,” and suggested CLOs were in danger of dragging down the economy, just as collateralised debt obligations (CDOs) had done in 2008.
That scenario never unfolded. Instead, CLOs are emerging from the pandemic as strong as ever. They set a record in 2021, when the Wall Street Journal called them “one of the top-performing credit assets” of the year. They’re still enjoying popularity among investors and have even evolved to include new features that make them more appealing.
Risk mitigation instrument
To understand CLOs’ current popularity, it’s worth going back to the aftermath of the 2008 crisis. With the world suddenly alive to the risks of sub-prime mortgage-backed securities and other retail obligations, CLOs became a prevalent financial instrument as the industry scrambled to adjust to new attitudes towards risk.
The appeal was obvious. CLOs are markedly less risky than CDOs, as they focus on senior or higher rated corporate loans rather than retail mortgages and provide testable portfolio safeguards designed to mitigate excess risk. As a result of their quality, CLO issuance volumes increased significantly over the subsequent decade. In 2019, volumes hit $110 to $115 billion in the US, the flagship CLO market and a bellwether for smaller CLO markets around the world.
There was a downturn in the CLO market when Covid first struck, but it proved temporary. With the sudden onset of uncertainty in the first half of 2020, ratings of several underlying loans were downgraded. Inevitably, this made yields volatile, and at the time, the market simply wasn't willing to price or structure CLOs.
Managers’ unwillingness to price new deals through the first half of 2020 had a marked effect on issuance volumes for the year, which dropped to $90 billion.
“Everybody likes to watch and wait in those circumstances,” says Navita Yadav, Managing Director and Global Head of Capital Markets. “The information was either staggered or not coming through at all, so nobody wanted to take a long-term view, and investment periods shrank to a bet of one or two years.”
Quick to recover
In the second half of 2020, the CLO market began to recover, and the ramp-up continued throughout 2021, which as we’ve noted was a record year for CLOs. Downgrades and defaults did not occur at the rates originally predicted, and full confidence returned to the asset class. The US market alone had $186 billion in new US CLO sales in 2021, and $850 billion outstanding.
“In 2008, the CLO community was told that the structure would experience unprecedented defaults because of a once-in-a-lifetime market crash, but not a single CLO defaulted during that recession,” explains Tim Ruxton, Director, Vistra Capital Markets, United States.
“In 2020, the CLO community was told to brace for a wave of downgrades and a negative rippling effect that would undoubtedly pummel the structure. But, again, CLOs have showed their resilience to market conditions.”
This enduring resilience makes sense. With CLOs, risk is highly diversified. More risk-averse investors are attracted to diversification at the AAA level, while high-reward investors are attracted to CLOs’ equity tranches. All of which suggests their popularity and demand among investors should remain buoyant into the future.
“There's been no significant change in the fundamentals of CLOs,” says Yadav. “The risk balance hasn't changed, and they continue to take advantage of senior corporate loans. The CLO recovery has been tremendous, and the world is set to keep on borrowing — more and more in fact, as the industry expands.”
With confidence returning, investment horizons are returning to four- and five-year timeframes. In fact, rather than damaging the reputation or long-term viability of CLOs, the pandemic introduced changes to the CLO structure that make the instrument even more appealing.
During Covid, many managers realized they were prevented from restructuring, resetting or reinvesting into the debt. So even though an asset was solid and was going to pay out in the long-term, managers felt bound to sell it at a price they wouldn't necessarily have settled on in steadier economic times.
The October 2020 amendments to the US’s Volcker Rule — part of 2010’s Dodd-Frank legislation — alleviated some of the difficulties managers faced. For example, the amendments allowed managers to participate in more restructures and created a segment for fixed-income securities within collateral portfolios. The added flexibility was helpful in the short term as managers waited out turbulence and price drops in the loan market.
“With the increase in new issuances, and with this new flexibility now granted by the Volcker rule into the documentation, CLO managers will have the option to take fixed-income securities like bonds into the structure, instead of just structured debt,” Yadav explains.
As yield spreads tighten, demand for CLOs goes up. And as this demand increases, the yield spread keeps shrinking. This is precisely what has happened in the pandemic recovery, with massive liquidity in the market and great interest in investing in risk-diverse asset classes.
“At the start of the pandemic, with the liabilities read widening, it was difficult to sell CLO equity, as the returns were unattractive,” Yadav says. “There has been a shift since, leading to more equity buyers returning.”
Libor and inflation
One factor in the 2021 CLO boom was the ongoing transition from Libor, the interest-rate benchmark for many CLOs and other financial products. As of 1 January 2022, banks are no longer able to issue loans connected with Libor (while legacy or outstanding debt has until June 2023 to transition). As a result, the end of 2021 saw many CLO issuers using Libor and closing deals against the 1 January deadline, as Libor offered favourable rates and was familiar to stakeholders.
Not surprisingly, many experts predicted a slowdown in CLO issuance in the beginning of 2022 as a result of the Libor transition. There was in fact a drop in issuances relative to the red-hot 2021, but the lull has been short-lived and CLOs may be in for yet another banner year. In a 2021 wrap-up article on CLOs, the Wall Street Journal noted that post-Libor, “many analysts expect CLO sales to meet strong demand,” with Bank of America and Barclays both projecting near-record CLO sales in 2022. These optimistic projections in the face of the Libor transition are more evidence of CLOs’ resilience amid disruption.
Another factor that could significantly affect CLOs is inflation, which in some parts of the global economy has reached a 40-year high. Higher interest rates could result in cash shortages for corporations in debt, which could in turn lead to loan downgrades. This could negatively affect CLOs if the downgrades are extreme, but few are predicting that, and CLOs are by their nature protected as they’re contractually restricted to a small percentage of low-rated loans. Furthermore, because CLOs are generally tied to interest rates, they’re seen as an attractive alternative to bonds during periods of rising inflation.
CLOs have shown remarkable resilience during two of history’s biggest economic crises. It should come as no surprise, then, that the instrument is experiencing continued popularity during difficult economic and political times characterised by inflation spikes, supply chain disruptions, military conflicts and other challenges.
The outlook for CLOs remains positive during this turbulent time in part because of investor demand, as CLOs continue to perform and provide good value relative to other asset classes. CLOs have also stayed buoyant in terms of loan supply.
Recent economic disruptions will likely spark further changes to CLO documentation. Changes could allow for greater “collateral obligation” flexibility, the ability to exchange assets for less risky elements, and greater options for managers to proactively defend against sudden, unexpected compliance obligations.
Given this outlook and their history of resilience during economic uncertainty, CLOs are likely to remain a compelling option in capital markets for years.
This is an updated version of a previously published article.
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