CLOs – Seeking Yield in a Negative Yield World (Just Like 2005-2007)

I just dropped in to see what condition the CLO market is in.

(Bloomberg) It’s a marriage between two of Wall Street’s hottest products.

Collateralized loan obligations — typically chock-full of broadly-syndicated debt — are increasingly being stuffed with private loans made to highly leveraged medium-sized companies with limited access to bank financing. Known as middle-market CLOs, the asset class has ballooned to $57 billion, from just $20 billion six years ago. Five new entrants this year — including Owl Rock Capital and PennantPark Investment Advisers — suggest issuance is only set to increase.

The frenzied growth is another example of how banks, insurance companies and pension funds continue to reach for higher-paying securities in the face of almost $15 trillion of negative-yielding debt around the world.

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Middle-market CLOs can offer premiums of as much as 200 basis points versus their garden-variety peers, in part due to the reduced liquidity that comes with direct lending, which bypasses traditional capital markets. Analysts say the products could saddle investors with even steeper losses if credit conditions sour.

“Some investors want the excess return to take on the illiquidity of the underlying middle-market loans,” said Michael Herzig, a portfolio manager at THL Credit. “You can’t trade a middle-market CLO the way you can broadly-syndicated ones. You really have to be diligent and careful when you structure.”

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About $10.4 billion of new middle-market CLOs have priced this year, according to data compiled by Bloomberg, near last year’s pace, which was the fastest since the financial crisis. Still, that’s dwarfed by about $80 billion of traditional CLO issuance. The $57 billion of middle-market CLOs outstanding compares to more than $600 billion of the conventional variant.

Middle-market loans also tend to carry more safeguards — known as covenants — than broadly-syndicated loans, where investors have recently started to push back against some of the riskiest financings.

Only about 30% of middle-market debt is covenant lite, versus 70% to 80% for loans sold to investors, according to Michael Boyle, a managing director at Bain Capital Credit.

On the other hand, the underlying debt in middle-market CLOs tends to be smaller in size, as many borrowers have annual earnings of $100 million or less. That makes the debt significantly less liquid compared to traditional loans. In addition, it makes the CLO bonds themselves harder to sell.

What is a CLO?

A CLO buys loans using money raised by selling debt in tranches of varying risk and return and a piece of equity. Interest from the loans goes in turn to pay the coupon on its different classes of debt. Buyers of CLOs include hedge funds, insurers, pension systems, and other big investors.

Let’s take a look at McAfee’s CLO. It is rated B by S&P and has a floater tranche at ICE LIBOR +375 bps. It is a Covenant Lite CLO.

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The loan is amortized with a payment due September 30th. The problem is … it is October 7th!

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As central banks continue to drive interest rates lower, we will see even more expansion into CLO markets as investors seek yield.