Collateralised loan obligations and some collateralised debt obligations, the structured debt instruments last in fashion prior to the financial crisis, have returned. And most of the transactions use special purpose vehicles in the Cayman Islands.
In its inaugural CLO Insider Report, law and fiduciary services firm Appleby noted that with US$47 billion of issuance, the first half of 2013 was the biggest half year ever in terms of value for CLOs and CDOs.
CLOs are structured bonds backed by groups of loans to below investment-grade companies. The banks that make the loans typically sell them to a CLO manager, who, together with an arranging bank, packages the loans into bonds that are sold to investors in varying tranches of risk.
CLO deals increased by 151 per cent in the first half of 2013 compared to a year earlier and even more compared to 2011.
“With the value of the CLO market growing over 260 per cent since 2011, it certainly seems that institutional investors are continuing to find value in CLOs,” says Julian Black, Appleby’s global head of Structured Finance. “With an estimated US$370 billion in assets under management and growing, this market is blossoming as CLOs offer attractive risk-adjusted returns, as well as low default rates.”
Appleby estimates that more than 90 per cent of the transactions are structured using special purpose vehicles registered in the Cayman Islands.
In total, 98 CLOs closed in the first six months of 2013, significantly more than the 39 deals in the first half of 2012.
Deals are also becoming larger. The average deal size for CLOs closed was US$482 million and the top 10 deals by value increased by an average deal size of $40 million over the second half of 2012 and $175m over the same period in 2012, the Appleby report shows.
For the remainder of the year, Black expects to see the re-emergence of other asset classes. “In particular, we are seeing commercial real estate CLOs re-emerging, and we expect to see this area as a growth sector going forward,” he said.
Even in Europe, typically a tougher market, some of the deals have re-emerged. But proposed regulatory changes could stall the market, says Black, although it is too early to say whether the EU Capital Requirements Directive (CRD IV), which transposes the Basel III bank capital standards into the EU legal framework, will have a significant effect on CLOs.
In addition to the generally larger deal volume, “the big thing this year has been the closing of CLOs involving European assets,” confirms Philip Paschalides, partner at offshore law firm Walkers.
“After several European CLOs we can observe the spread of CLO issuance from North America over to Europe.”
In the wake of the financial crisis, CLO issuance had dropped significantly from nearly $100 billion in 2007, together with structured credit transactions in general.
Collateralised debt obligations, securities that hold different types of debt, such as mortgage-backed securities and corporate bonds, that are then sliced into varying levels of risk and sold to investors, disappeared entirely. In particular, CDOs backed by risky subprime residential mortgage-backed securities were considered one of the culprits in the financial crisis.
But even the CDO market has reappeared, albeit in different asset classes, such as commercial, rather than non-agency residential, mortgage-backed securities.
While CDOs outweighed CLOs prior to the credit crisis, the proportion has changed, says Paschalides. “CLOs represent by far the majority of structures and transactions in the North American market. Other asset class issuance is not quite as robust as it was in 2005 and 2006, which is also a contributory factor.”
In part, this is because investors have a little bit more confidence in the CLO product and the underlying asset class, which fared better than others during the crisis, he says.
Even though the underlying loans are made to creditors with a low credit rating, often because they have a high level of debt after a leveraged buy-out for example, the diversification effect of the CLO structure means that some tranches of a CLO attain the highest AAA rating, indicating they are less risky.
In contrast to subprime mortgage-backed security CDOs, this has proven correct in practice as after the crisis default rates of CLO collateral peaked significantly lower than the default rates of corporate loans overall.
At the same time, returns were higher than investments in individual loans.
Another reason for the return of CDOs and CLOs is that they are in principle an effective risk management tool that allows for the diversification of, otherwise quite concentrated, risk.
Amid the big push to lend to corporate America and stricter regulatory capital requirements, banks are looking to collateralised debt instruments to free up capital. Deutsche Bank, for example, reportedly managed to raise its core tier 1 capital ratio by issuing a $8.7 billion CDO in late 2012 and taking riskier assets of its balance sheet.
“Because of the state of bank balance sheets, banks are not able to lend as much as is needed to boost economic activity. The CLO is a terrific vehicle that can absorb financial assets originated by banks and allow greater exposure to this for investors, ultimately allowing finance houses to originate more credit,” Paschalides says.
Compared to pre-crisis deals, current transactions are more transparent and provide investors with more information about the underlying collateral.
CLOs now also address some of the deficiencies in the documentation and contracts highlighted by the credit crisis. For example restrictions are limiting non-core investments by CLO managers and require a substantial majority of CLO portfolios to be invested in senior secured, broadly-syndicated, leveraged loans, according to Chris Culp, adjunct professor of Finance at the University of Chicago Booth School of Business.
Tighter restrictions also apply to other collateral, for example relatively higher-risk covenant-lite and second-lien loans, as well as exposures to non-US borrowers.
“What we have seen is the building in of certain mechanisms that engineer some of the lessons learned from the pre-crisis CLOs, but not a major structural change,” says Shamar Ennis, associate at Walkers.
Rating agency Fitch has also begun to publish CLO indenture abstracts which describe important features of individual CLO contracts, giving investors the ability to compare deals with previously issued CLOs, allowing for significantly enhanced transparency, she adds.
The varying risk tranches of CLOs attract different sets of investors.
Japanese banks and US pension funds are typically investing at the AAA level, where yields were around LIBOR plus 140 bps at the end of 2012, the Appleby report said. Due to the demand for CLOs, spreads on AAA’s have since narrowed, dropping to near 115 bps in the second quarter of 2013.
Banks that invest in CLOs can take advantage of significantly lower regulatory capital requirements for the AAA-rated tranches of CLOs than for the underlying corporate loans.
Given a set amount of capital, it means that banks using leverage can invest up to five times as much in CLOs than they could in individual leveraged loans.
Meanwhile, investors in the riskier tranches of CLOs are attracted by comparatively high yields in the current low interest rate environment.
The CLO product is also attractive to an asset manager because it provides a relatively predictable income stream from management fees which are based on a cashflow structure, says Paschalides.
The CLO market is dominated by core set of arranging banks, the Appleby report shows. Citigroup is leading the ranking in the first two quarters of 2013 with 20 deals worth $9.5 billion, followed by Bank of America Merrill Lynch ($6.5 billion), Morgan Stanley ($6.1 billion), Wells Fargo ($4 billion) and RBS ($3.6 billion).
The number of CLO managers in turn is growing, with new managers joining the larger established ones.
“We are still seeing a lot of repeat deals and repeat managers, but we have a lot of new managers coming to the market. These are typically fund managers looking to develop further in the credit space through rated structures that access the debt capital markets,” says Walkers associate Nadine Watler.
Based on its pipeline, Appleby is seeing a further big push of deals coming up in the third quarter. “This is again dominated by large repeat-issuer clients moving on to their next transactions, together with a number of new entrants to the market,” the firm said.
For the next quarter, Appleby also expects the re-emergence of other asset classes, such as commercial real estate, and a further development of the European market.