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CLOs: Corporate Loans Sliced, Diced and Worrisome

CLOs: Corporate Loans Sliced, Diced and Worrisome

(Bloomberg) -- A decade ago, risky subprime mortgages were supposedly made safer when they were packaged and repackaged into bonds. Instead, those securities ended up blowing up the global financial system. Now investors are clamoring for risky corporate loans that are being similarly bundled into notes -- and global regulators are watching closely, hoping to make sure history doesn’t repeat.

1. What kind of debt has regulators worried?

Collateralized loan obligations, or CLOs. If that sounds familiar, you may be thinking of Collateralized Debt Obligations, or CDOs, which became famous after melting down in the runup to the 2008 financial crisis. Both are structured finance products created by pooling loans to create securities sold to investors. While CDOs cover a wide array of debt, CLOs are built from leveraged loans -- sub-investment grade loans to companies with high levels of debt, or leverage.

2. How are CLOs made?

The CLO manager -- usually an asset manager or an asset management arm of a bank -- buys anywhere from 100 to 350 or more loans. Those purchases are funded by groups, or tranches, of the bonds, each with a different risk and return. The highest ranking have first dibs on the cash flow generated by the underlying loans. CLOs also offer equity stakes, which are the last in line to receive cash flows but the first to realize losses from the loans. It’s the riskiest but potentially but most lucrative piece.

3. Are there a lot of CLOs?

The U.S. market has more than doubled since 2008, growing to about $600 billion in outstanding debt. They’ve become a big part of financing corporate America -- about 60 percent of loans to sub-investment-grade firms are bought to be folded into CLOs. Supporters of CLOs say they’ve kept corporate financing available and affordable, thereby feeding economic growth.

CLOs: Corporate Loans Sliced, Diced and Worrisome

4. What’s the appeal for investors?

Yield. That is, these riskier companies pay more to borrow. Ever since interest rates hit the floor in the wake of the financial crisis, a growing number of investors have been willing to take on more risk for greater rewards. On March 1, a AAA CLO note paid about 133 basis points above its benchmark rate, while a similarly rated corporate bond paid 61 bps more than its benchmark. Another part of CLOs’ appeal is that both the underlying leveraged loans and the CLO bonds have floating rates, meaning they generate higher yields as rates go up, unlike most corporate bonds. That was a big factor in the last two years as the U.S. Federal Reserve began to push up rates, though the Fed has paused those hikes for now.

5. Who buys and sells them?

The biggest issuers include the likes of Blackstone’s GSO, CIFC Asset Management, PGIM Inc. and Credit Suisse Asset Management. While CLOs are sold globally, 75 percent of the market is U.S.-based. In terms of buyers, insurance companies and pension funds focus on the safest bits, and tend to hold them for the longer term. Banks are also big buyers: Wells Fargo & Co., JP Morgan Chase & Co., and Citigroup Inc. are the largest holders of U.S. CLOs, according to Citi research. There’s also a significant Asian market, with Japan’s Norinchukin Bank and Japan Post among the big buyers.

6. What went wrong with CDOs?

Pioneered in the late 1980s, CDOs created tradeable securities from assets that many investors had been unwilling to invest in directly. That in turn helped funnel cash to companies to grow their businesses. Then things got out of hand. CDOs stuffed with sub-prime mortgages or more exotic versions imploded in 2007 and 2008 when the U.S. housing mortgage market had soured.

7. Are CLOs as risky as that?

There’s some debate. CLOs fared well in the 2008 crisis, with none of the highest-rating tranches defaulting. In some ways, CLOs have gotten safer since then: Now they can only buy leveraged loans, which are typically senior in a firm’s debt structure, meaning they get paid out first in a default. And ratings agencies require CLOs have more of a buffer between the value of the loan pool and the value of the debt, known as over-collateralization, among other tests designed to shield investors from losses. The industry also points to the diversity of loans CLOs hold, making them less susceptible to collateral damage -- literally. So if one industry gets hammered, the way the energy sector was in 2015 and 2016, stronger sectors can make up for it.

8. Why are regulators worried?

Even the biggest boosters of CLOs acknowledge that they’re complex investments with risks that need to be understood. Since the Fed discouraged banks from holding too many leveraged loans, a bigger share of the loans has been bought by investors outside of regulatory purview, making it more difficult for regulators to keep tabs on the health of that market. Another concern is if the business cycle turns and companies in a wide range of industries are downgraded, which would make it harder for the CLO machine to function since they have have limits on how many lower rated loans they can hold. Also, as demand has grown, borrowers have been able to water down the covenants, or protections, that are written into the loans to protect investors.

9. What are regulators doing?

The Financial Stability Board, made up of regulators from around the world is reviewing the global leveraged loan market, with a focus on CLOs -- a first -- as part of its work to spot stress in the financial system. Bank of England Governor Mark Carney, former Fed Chair Janet Yellen and the International Monetary Fund are among those who have voiced concern over the pace of growth in the leveraged loan market and weakening documents. In Japan, the Financial Services Agency has introduced a rule to penalize banks that buy CLOs from parties that don’t retain a stake in the underlying loans.

The Reference Shelf

  • A look at Wall Street’s “CLO machine” and the fortunes it’s made.
  • The Financial Stability Board’s 2019 global report on non-bank financial intermediation.
  • How CLO managers are preparing for a possible economic downturn.
  • A top Federal Reserve official’s 2018 warning that CLO investors may be taking on too much risk.

To contact the reporter on this story: Sally Bakewell in New York at sbakewell1@bloomberg.net

To contact the editors responsible for this story: Shannon D. Harrington at sharrington6@bloomberg.net, John O'Neil, Dan Wilchins

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