Collateralized loan obligations, desperate for collateral, are being loaded with junk bonds
To revive a lucrative CLO machine, fund managers must stretch the bounds of what is
considered as collateral for these transactions. Collateralised loan obligations are a form of collateral,
as their name indicates, intended to combine leverage loans, the type of debt that is usually followed
by holders' first claim in default.
But more and more, collateralized loan obligations will be borrowing from a different kind of debt
that is junk bonds for the security package underlying investment vehicles sold to insurers and
pension funds. According to data from Morgan Stanley, the proportion of collateralised loan
obligations in Europe which have been backed by 16 % of junk bonds has reached a new high.
As compared to three years ago, 9% of the portfolios had fixed coupons; this is double the allocation.
The difference, to the untrained eye, may appear to be a split in hairs. The revenue generated by
either loans or bonds is used to cover the interest and principal payments of CLO bonds. However,
there is a crucial distinction: in the event of a default, loans have a higher priority for repayment.
They offer interest rates that fluctuate, aligning closely with the interest schedules of the CLOs, in
contrast to junk bonds which typically provide fixed rates. Andrew Lennox, a portfolio manager at
Federated Hermes and a buyer of CLOs, emphasized that managers should not forget that a
collateralised loan obligation is essentially a loan.
The statement suggests that while bonds have traditionally been used to manage the liquidity of a
CLO, it is important to note that fixed-rate bonds come with interest rate exposure, which is not part
of the original thesis. Last year, due to a shortage of leveraged loans, the CLO machine was shut
down.
In Europe, many M&A deals have been stalled this year, as valuation expectations have diverged,
because loans typically emerge from private equity led buyouts, but many M&A deals have been
stalled in Europe this year, since loans typically emerge from private equity led buyouts.
Thus, when demand returned for Collateralized Loan Obligations themselves, there was a lack of
collateral on the part of CLO managers. So they are going outside the bounds of their normal duty by
issuing junk bonds. In view of the restrictions on US deals by the Fed, which limit pools to 5 % of
bonds, this trend is more eurocentric.
The limits are relaxed by the European Commission and the managers of CLOs are allowed to allocate
up to 30% of the bonds. Some of them are trying to take it a step higher. Laila Kollmorgen, a portfolio
manager covering European CLOs at PineBridge Investments, noted that some managers are
increasing those buckets to 35% from the previous 30%.
Observations indicate that this is becoming a common occurrence. Managers find these vehicles
profitable. They earn approximately 7% yields on the junk debt they invest in. Meanwhile, they
generate funds by selling bond-like instruments that yield between 6.23% and 13.42%, as per the
CLO indexes of PalmerSquare.
Indeed, these vehicles are so profitable that even hedge funds, such as the one established by Hamza
Lemssouguer, a former star trader at Credit Suisse Group AG, are making their way into the
marketplace. For the collateralised loan obligation pool, there are other reasons for supplementing
loans with junk bonds.
Junk bonds usually return to their original face value of, say, 100 cents as they approach maturity and
investors are expecting them to be repaid. On the contrary, it is possible that loans have prices which
are cheaper but may be more difficult to discern due to their small number of transactions.
When managers of collateralized loan obligations build enough loans to enter the market, they are
storing them in warehouses and this poses a risk that older loans will lose value. The demand from
CLOs has been a boost to bondholders who sell junk bonds. According to Morgan Stanley, the shares
of euro High Yield Markets held by CLOs have risen from 5.5% last 18 months to 9.0% today.
This has led to an increase in the issuance of floating-rate notes (FRN), which are preferred by CLOs.
According to the Bloomberg data, they are accounting for about 15% of all new junk bond sales this
year compared with 7.1% in 2021.
Ben Thompson, who is the head of EMEA leveraged finance capital markets for JPMorgan Chase &
Co., suggests that if a new issue is introduced in the high-yield FRN format, it will attract significant
participation from the CLO community.
According to people with knowledge of the matter, both Icelandic food producer Iceland Foods Ltd
and Travelodge Hotel Ltd have introduced their first Euro Floating Rate notes this year in order to
take advantage of demand for CLOs. No response to requests for comments was given by the
companies' spokespeople.
Vasundhara Goel, an analyst at Morgan Stanley, has observed that CLO managers are persisting with
their engagement in the bond market due to the lack of significant activity in the loan market. The
belief is held that the current trend will persist if the supply of loans does not resume.