Getting an attractive yield on your investment while playing it safe sounds like a great combination, but this is not true when you are investing in collateralised loan obligations (CLOs).
When talking about CLOs, the main discussion always quickly goes to the CLO market pre- and post-economic crisis; the evaluation on how CLOs were set up, and to what extent investing through CLOs would be considered a safe and beneficial investment strategy.
CLO issuance and their role in a wider economy
A CLO is structured via an orphan structure which issues tranched notes (liabilities) that are secured or collateralised by a portfolio of leveraged loans. The supply (shortage) of leveraged loans is a significant hurdle for further issuance, together with regulatory issues or uncertainty about upcoming regulations.
We have seen a high leveraged loans issuance in the US and Europe, but the majority of that has been refinancing. There has been little issuance of new or fresh loans as many corporates on both sides of the pond have taken the opportunity to refinance against lower spreads. However, over the last couple of months, we have seen a pick-up in leveraged loans in Europe, which will be warmly welcomed by the CLO commare unity.
CLOs are consuming around 50% of the primary loan issuance, so they play an instrumental and undeniable role in the financing needs for non-investment grade corporations. These corporates can fund themselves against attractive rates, invest and innovate - creating jobs in the process.
Today there is approximately €120bn of CLO paper outstanding in Europe, invested mainly in non-investment grade corporations. This shows that CLOs play a big part in local economies and their role should not be underestimated.
The preferred jurisdictions for CLOs
Since the inception of the European CLO market in 1999, the Dutch and Irish Special Purpose Vehicles (SPVs) have been used for issuing Euro CLOs. Before the economic crisis, CLOs and Collateralised Debt Obligations (CDOs) were referred as “CLO 1.0”. In the 1.0 era, Luxembourg also evolved into a CLO preferred jurisdiction. After the crisis in 2013 and the subsequent revival of CLOs (known as the “Euro CLO 2.0” era), there was only one CLO issued from Luxembourg, which was technically a refinance structure. This is currently closed.
- A solid legal framework
- Political stability
- Favourable tax regime, however, CLO transactions are not tax driven
- Well-regulated jurisdictions (compliance).
- Skilled staff, infrastructure, and long track records
- Wide network of tax treaties (70 for Ireland, 90 for the Netherlands)
- No or limited capitalisation requirements
- Quick set up of the CLO-SPV.
Taking the above advantages into consideration, the final choice between the Netherlands and Ireland is mostly driven by the comparison between tax treaties, regulatory treatment, initial set up and recurring costs.
Investing in CLOs
CLOs are structured via a well proven and robust manner. As a bonus, most are set up in well-regulated and safe jurisdictions.
The notes issued are divided into debt and equity tranches. The debt tranches or notes, are rated by an independent rating agency and listed. The highest rated notes are assigned to a triple A (AAA) rating and are paid back first. These are the safest, yielding “lower” interest returns, which are priced around 90 base points above Euribor these days.
The equity tranche (economic equity) absorbs the first losses and is entitled to the residual income on interest payment dates (typically quarterly).
For all tranches, the yield is there. So, what about the risks? According to Moody’s review of the CLO market over the last 20 years, CLOs have had very strong performance compared to other fixed income instruments. In the top of the capital stack, AAA to Baa1, losses are negligible. Starting at the Baa2 level, losses only account for 0.1%. As we already concluded that the yield is there, we can now conclude that the risk isn’t.
In short, CLOs have performed better than any other investment grade bonds, with near invisible default rates.
Given the outstanding performance over the last 20 years in Europe, one could argue that AAA CLO notes represent the new risk-free benchmark. CLOs in Europe and in the US have proven to be robust, safe, reliable, and well-performing structures - even during the economic crisis. What’s more, they have survived the worst economic crisis. There is no better marketing tool for CLOs than to look at those charts. And for the icing on the cake, they give a very handsome yield as well.
Given the current interest rate environment and the hunger for yield, it is no surprise that CLOs are gaining more interest from new and returning investors, no matter where in the capital stack.