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 have emerged from the pandemic as strong as ever. They are enjoying soaring 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.
It is true that when Covid first struck, there was a downturn in the CLO market, 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 has continued into 2021. Downgrades and defaults did not occur at the rates originally predicted, and confidence returned to the asset class. The US market expects to see $100 billion of new CLO issuance in 2021, and the European market $25 to $30 billion of new issuance, according to Yadav. In each case, that would be a spectacular return to pre-Covid levels.
“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 has 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’s happening 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 spread 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.”
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 increasing popularity as the world begins the difficult task of putting its economic structures back together in the wake of the pandemic.
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.
The economic disruptions of the pandemic 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.
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