How Market Turmoil Presents Opportunities in CLO Equity Investing

Recently, we sat down with Robert Klein, President and Chief Investment Officer of Structured Credit at Clarion Capital Partners for a series of conversations.

We began with investing insights from across Robert’s career in our first conversation: “From Art History to CIO: Meet the leader of Clarion Capital Partners’ CLO Brain Trust.”

In the discussion below, we continue our dialogue with Robert and learn how CLO equity (and mezzanine) investing can benefit from market turmoil and economic uncertainty, which may seem counterintuitive at first.

When we spoke last, you revealed the “ah-ha” moment for Clarion Capital Partners that brought you to the firm.

As we discussed, Clarion starts with some basic questions when considering any investment strategy. At a high level... Is it a good strategy? Does the strategy provide distinctive sources of profits? Does the strategy offer the potential for high returns with limited and quantifiable downside risk? That goes to Clarion’s core philosophy of asymmetric risk award. CLO equity fits very well into that philosophy. Meaning, can you understand and corral or manage the downside risk and at the same time see significant layers of upside?

“Does the strategy offer the potential for high returns with limited downside risk?”

Do you remember the actual “ah-ha” moment for Clarion Capital Partners?

The ah-ha moment was when we showed them how CLOs can actually do better when markets and the economy get worse.

How is that possible?

It’s not a premise in credit you would naturally come to. If there is a recession or a financial crisis, elevated defaults follow. You typically would think that any strategy that involves credit or lending would do worse in those periods. However, CLO equity can actually do better in those periods.

Sounds like a paradox. Explain.

The fundamental economics of CLO equity are that your cost of capital doesn’t change in those periods. When you create a new CLO, the debt that you use to finance that CLO is locked up for 10 to 12 years, but the assets keep turning over through active portfolio management and you’re reinvesting across a multi-year reinvestment period. When markets become volatile, and there’s more credit stress, underlying loan borrowers have to pay more for new financing. And as CLO loan portfolios turn over and get reinvested in loans with higher spreads, you as the CLO equity investor benefit from these wider loan spreads and earn higher yields. Your net interest margin or the net profit to the CLO equity increases.

Help us understand this.

I like to use the real estate analogy, even though CLOs have nothing to do with real estate. The investment grade CLO tranches are like having a mortgage—not a mortgage backed by commercial buildings, apartments, or anything like that. CLO’s are backed by portfolios of bank loans to large corporate credits like American Airlines, Burger King, Uber, Dell Computer, and the like.

Keep going.

Imagine we bought an apartment complex with 400 units. We used a mortgage for 90% of the purchase price. We put up the remaining 10%. So, as the landlord, what is our P&L? What does our profit outlook look like? Well, every time a tenant moves out, we can raise the rent. Our mortgage cost doesn’t change, but each time a tenant moves out, we can raise the rent for that spot in our revenue portfolio. That increases our net interest margin or our net profit margin. That’s how CLO equity functions. That’s one way CLO equity can actually do better in a downturn.

What’s the tradeoff?

In a downturn, you will have more credit losses. However, a healthy portion of the portfolio increases its spread. The compounding effect can more than offset the credit losses. That’s the inspiration behind the ah-ha moment: spread widening drops to the bottom line and more than compensates for the increase in credit losses—virtually every time, historically. Though as risk managers we remain ever vigilant.

But why use a CLO? Can’t you just invest in an ETF? Isn’t that simpler?

If you’re going to have exposure to non-investment grade corporate credit, you want to do it in a CLO. Historically, if you just bought the leveraged loan index through an ETF, you are actually going to have more credit losses than if you were in a CLO.

How does a CLO provide fewer credit losses?

Let’s talk about history. In the Global Financial Crisis of 2007-2008, the “hundred-year flood” of corporate credit, defaults in the leveraged loan market peaked at north of 10% for two quarters. But if you held your leveraged loan exposure through CLOs, the peak default rate was only 6%.

Why so much lower?

To start, active management made a big difference. CLO collateral managers can trade out of deteriorating credits. You cannot underestimate the importance of active management when managing the underlying collateral portfolio for a CLO. Combine that with the ability to reinvest at higher yields. That makes a big difference. An effective CLO collateral manager can both reduce risk and improve yields.

“An effective CLO collateral manager can both reduce risk and improve yields.” 

So CLO manager quality makes a difference? 

Exactly. We examined the track record of our preferred CLO collateral managers. In the GFC, their default rate for their underlying loans peaked at 5%, well below the 6% default rate seen among the broader CLO market. Our team of managers cut the “hundred-year flood” credit losses in half, from 10% to 5%. We consider the extra edge to be manager selection alpha.

Why else would CLOs have lower default rates in periods of stress?

Good question. Let’s start with diversification. First, CLOs hold highly diversified portfolios by mandate. No more than 1% in any one borrower. No more than 10% in any one sector. There are very small slices of hundreds of different borrowers in any one CLO. That granularity helps avoid increased defaults when larger borrowers get into trouble.

Is diversification enough if leveraged loans overall are under pressure?

Diversification is just a start. The other element is the tradability of these loans. Tradability is a crucial difference between the securitization of bank loans and securitizations of almost any other type: student loans, credit cards, automobiles, mortgages. Most asset-backed securitization have fixed portfolios (also known as static portfolios). The portfolio is not tradable. You can’t take a car loan for a Ford truck, trade it out, and put in a Toyota truck loan instead, just to pick a crazy example.

Was that one of the problems with the static mortgage collateral pools during the GFC

Exactly. To quote the rules of kindergarten, you get what you get and you don’t get upset. Static portfolios leave the manager of that portfolio with no ability to trade in and out of different loans when there are prospects for default. Some investors like the idea of a fixed portfolio of assets, but there’s no opportunity to adjust when really necessary.

But what about the liquidity of the loans within CLOs? Don’t they only trade by appointment? 

Actually, leveraged loans have an active trading market. The leveraged loan market is $1.4 trillion in size. They trade similar to high yield bonds. You can get quotes from multiple investment banks for your loan to Burger King, for example. You can get a bid if you’d like to sell your Burger King loan and buy a loan in American Airlines instead. The tradability of these loans helps bring down that default experience in CLOs dramatically. Tradability is what helps make the CLO structure fundamentally different. This dynamism is integral to our strategy.

Tell us more about how your approach to CLO investing can be dynamic. 

In our strategy, we move between primary markets, meaning new CLOs, and older vintage CLOs that might trade in the secondary markets. Where can we find the best relative value, the best risk-award for our investors? Sometimes, we even pivot between the tranches of CLO we’re buying, and may go up the capital stack.

Give us an example.

Sometimes, instead of CLO equity, we’re buying CLO mezzanine securities, the debt layer right above equity. Over cycles, we move back and forth between the different CLO sub-markets and layers, depending on where the best value is. Generally speaking, when there are downturns, we are less likely to be buyers of primary new issue CLOs, and we’re more likely to buy secondary transactions; secondary CLO equity and secondary CLO mezzanine.

In those periods, there may be nothing wrong with the CLO, but some owners become forced sellers of those securities.  Very often it’s hedge funds that are getting investor redemptions. 

So we will move into those environments and carefully pick through what’s coming onto the market. We become eager buyers of those securities, sometimes at significant discounts to nominal face value.

What are the biggest discounts you’ve seen recently?

The pandemic-driven investment crisis of 2020 provides a notable example. Starting in March 2020 and through the spring, we were able to purchase CLO double-B securities at anywhere from 45 to 55 cents on the dollar. Again, we felt that there was nothing fundamentally wrong with the CLOs we were buying.

Sounds like you prefer market setbacks as buying opportunities.

We find some of our best opportunities in periods of stress.

“We find some of our best opportunities in periods of stress.”

But downturns must still be risky for you.

They can be. But we strive to underwrite our portfolios to withstand difficult periods. We seek CLO managers and deals that are ready for what storms may come. Markets are not going to move smoothly across business and credit cycles; plus there are exogenous shocks.

Remember 2018 and 2019? We were finishing a very long stretch of positive economic movements. We didn’t think that would continue forever. At a time like that, we don’t seek to maximize cash yields by buying CLOs with the spiciest loans. The borrowers who are paying the highest interest rates in good times are probably paying that for a reason. Often, those high paying loans are rated triple-C, that way station between a single-B credit rating and default. There’s a good reason why CLO governance documents limit the amount of triple-C securities in their underlying portfolios.

But some CLOs still hold a bit more triple-Cs?

Indeed. Some CLO pool managers raise the level of triple-Cs to increase current yields. Some CLOs see rising levels of triple-Cs in a downturn. The rating agencies apply triple-C ratings to businesses that are not doing well or that are fundamentally more risky. We saw CLOs in 2018 and 2019 that had higher cash yields, but were simply holding more triple-C loans. They were stirring a spicier stew. We put together a portfolio with Goldilocks in mind: not too spicy, not too many CLOs with triple-C holdings.

Did you know the pandemic was coming?

Of course not. We didn’t know a pandemic was coming, but we knew that eventually there would be a business cycle, and downgrades and even defaults could follow.

The financial turmoil that accompanied the pandemic became a test of the CLO structure. The pandemic highlighted the “self-healing” characteristics of CLOs.

“We didn’t know a pandemic was coming, but we knew that eventually there would be a business cycle…”

Can you explain the concept of “self-healing” in CLOs? Sounds like a medical phenomenon.

Not medical, but financial. CLOs are designed with a host of protections for investors. The self-healing mechanisms of CLOs are designed to guard against the deterioration of the underlying portfolio. The goal is to sustain the cash flows and the collateral quality of the portfolio to assure payments of interest and principal first to the senior tranches and then the junior tranches. It starts with tests.

What are the tests?

CLOs have mandatory collateral and interest coverage tests. These tests are monitored and reported monthly by every CLO trustee. There’s a variety of tests. The most important of these tests are the interest coverage and over-collateralization tests. These tests are vital in detecting and correcting credit deterioration. The tests directly affect the allocation of cash flows among CLO tranches.

What is the interest coverage test?

Interest coverage tests require that the income generated by underlying loan portfolios (assets) must be greater than the interest due to outstanding CLO debt tranches (liabilities).

Now tell us about the over-collateralization test.

Over-collateralization tests require that the principal or par amount of the underlying loan portfolios is greater than the principal or par amount of outstanding CLO debt tranches.

What happens if a CLO fails these tests?

That’s where “self-healing” comes in. If a CLO comes up short on either of the tests, the CLO must divert cash flows from the CLO equity tranches -- or even the junior debt tranches in a severe case -- to retire the most senior tranches. This reduces the leverage and risk in the CLO structure. Cash flows to the CLO equity can resume once test results move back into compliance.

“The self-healing mechanisms of CLOs are designed to guard against the deterioration of the underlying portfolio.”

Are there any other tests?

As an additional protection, CLOs also have an interest diversion test for the lowest-rated debt tranche. This test is similar to the over-collateralization test. However, the interest diversion test for CLOs triggers a different self-healing action. Instead of diverting cash flows to de-lever the CLO structure, cash flow is diverted from the equity tranches to purchase additional loans for the portfolio. This increases the CLO’s collateral balance.

Sounds like multiple layers of self-healing.

Exactly. Either the CLO de-levers by paying off the senior tranches, or the CLO buys more loan collateral to strengthen the underlying portfolio.

What happens if the underlying loans get downgraded?

Downgrades are built into the tests. There can’t be too many loans with a triple-C rating. Not more than 7.5% of the loan portfolio, in general.

Don’t these self-healing mechanisms work at the expense of the CLO equity?

CLO equity ultimately benefits from strengthening the collateral portfolio. The price to pay in the interim is a reduction or suspension of cash flows to CLO equity in times of distress.

How bad can that get?

The pandemic was the most recent challenging period for CLO equity cash flows. 24% of the CLO equity universe in the U.S. had either a complete or partial interruption of the dividend to the equity in the July 2020 quarterly payment cycle.

24%? Isn’t that high? What happened next?

CLOs are a bit like a bank. When the environment is troubled, and the trouble hits the loans in the portfolio, a bank might suspend the dividend to their shareholders to fix the ship. CLOs are similar. When there’s a reduction or suspension of the dividends, there’s a redirection of that capital to either buy more loans to build the asset side of the balance sheet or pay off some of the triple-A tranche to reduce the liability side. That’s good news for CLO equity. Once the self-healing process is complete, the cash flows to CLO equity can resume.

So bad news can be good news?

That’s one way to put it. When those tests are activated, you’re actually adding value. If it’s a problematic time in the marketplace, a period of credit stress, more loans are probably being bought at a good value. Alternatively, dividend proceeds will go to pay down the triple-As and de-lever the structure. It’s all about de-risking. It’s all designed to get a CLO’s collateral-to-liability ratios back in line.

In fact, if the CLO’s self-healing mechanism goes into effect, it would actually be good for the mezzanine tranche. With one of the mezzanine issues we bought in the pandemic downturn, the self-healing mechanism led to the suspension of the dividend to the equity tranche. They took $3 million that would’ve been paid out to the equity and paid down the triple-A tranche. The amount of securities higher in the capital stack went down, leaving more of the cash flow for lower-rated and mezzanine tranches. As a result, our double-Bs actually rose in credit quality during the pandemic crisis and downturn in credit.

How bad did it get for you in the pandemic? How many of Clarion’s CLO equity holdings saw cash flow interrupted?

None.

None?

None. We work hard to analyze the risk of our CLO equity, mezzanine, and warehouse investments before we invest. We analyze the structure, the underlying loan portfolios, the range of CLO holdings, and the expertise of the CLO collateral manager. We try to be mindful of the risks in the credit markets. We try to select what we believe will be resilient CLO investments. During the pandemic, our portfolio avoided all those CLO equity payment interruptions.

Does avoiding risk mean lower returns?

Not necessarily. Our CLO holdings provided above-average cash flows while exhibiting less risk. We try to construct a Goldilocks portfolio. Not too spicy. A bit of extra cash flow. Just right.

Thank you, Robert. We’re looking forward to our next conversation.

“We work hard to analyze the risk of our CLO equity, mezzanine, and warehouse investments before we invest.”

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