Investor Thinking - CLO Equity: pools of opportunity at the bottom of the CLO cash-flow waterfall
Investors in the equity tranches of Collateralised Loan Obligations (CLOs)1 assume the highest share of risk of all CLO tranche holders. They also stand to achieve the highest returns. CLO Equity has outperformed most other asset classes over the past decade.
CLO equity tranches are at the bottom of the CLO structure and receive the excess cash flows only after the satisfaction of the coupon or principal payments to the CLO debt tranches. Despite this, investors have typically enjoyed robust, high front-loaded cash flows associated with a moderate duration.
Why take a look beneath the surface?
The annualised performance of CLO Equity in the 10 years to the end of 2016 (16.7% on 2005-2007 vintages)surpasses that of most other asset classes including private equity (10.0%), equities (6.9%), and high yield (7.1%) by a considerable margin.2 The CLO market has evolved substantially over the past decade, while maintaining a set of core characteristics that underpin its investment case, as noted in our paper, “Collateralised Loan Obligations: Rebooted”. The same holds true for the equity tranches of CLOs, which represent approximately 10% of the €500bn CLO market3, but which may be less well understood than the debt tranches of the CLO capital structure.
CLO equity tranches sit within the credit universe but have characteristics – including cash flows and return drivers as well as behaviours in a rising spread or in a crisis environment – that present opportunities and risks that may differ from other credit investments and which we investigate here.
Characteristics of CLO equity tranches
First risk loss
CLO tranches form a range of securities backed by a diversified and managed pool of corporate loans: these securities are credit securities spanning from senior AAA-rated debt to equity. The equity tranche of a CLO bears the first loss that could occur at the underlying loan pool level. It acts as an insurer for the CLO debt tranches.
In return, CLO equity tranche investors are given significant control over the length of the life of the overall CLO structure (equity and debt tranches) and are entitled to receive the excess cash flows after payments to the CLO debt tranches from the most senior to the most junior according to the CLO waterfall (Figure 1).
The potential cash flows of a CLO equity investment are closely associated with the different phases in the collateral management cycle (Figure 2).
1 A collateralised loan obligation (CLO) is a range of securities backed by a diversified and managed pool of corporate loans.
2 Source: Standard & Poor’s (S&P 500 Index – US Equity), Citi Research (Citi US High Yield Bond Index), Wells Fargo (Equity CLOs) and Cambridge Associates (US Private Equity) as of December 2016, AXA IM analysis. CLO Equity 1.0 and 2.0 returns correspond to the average return between US and European samples. Past performance is not a reliable indicator of current or future performance. Historical market trend are not reliable indicators of future market behaviour. Actual results may vary and the variations may be material.
3 Source: Wells Fargo Securities, estimate as of December 2016.