Harnessing the unique characteristics of CLO Equities for a credit portfolio
- CLO equity tranches, that receive excess cash flows after coupon and principal payments to the CLO debt tranches, bear the highest risk and exhibit the highest return potential in the CLO structure.
- Outperformance vs other high yielding assets classes over the past decade, a possible positive response over the mid term to a rising credit spread environment, high front-loaded cash flows and moderate duration, are compelling potential characteristics of this asset class.
- Institutional investors familiar with CLO debt would do well to consider the distinctive nature of CLO equities and how CLO equity exposure can improve the risk-return profile of their portfolios.
Incorporating CLO equities’ high potential cash flows into institutional portfolios
The annualised performance of CLO equity in the 10 years to the end of 2016 (16.7% on 2005-2007 vintages) surpasses that of many other asset classes including private equity (10.0%), equities (6.9%), and high yield (7.1%) by a considerable margin.1
CLO equity tranches sit within the credit universe but have characteristics including high potential cash flows and behaviours that may differ from other credit investments. Their incorporation in portfolios, which we investigate here, could offer attractive diversification benefits to institutional investors.
Characteristics of CLO equity tranches
First risk loss
The equity tranche of a CLO bears the first loss that could occur at the underlying loan pool level. 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.
High front-loaded cash flows
The potential cash flows of a CLO equity investment display a unique front-loaded pattern which generally makes CLO equity tranches moderate duration instruments – typically close to four years in the absence of any severe market dislocation.
During the reinvestment period (see Table 1: CLO management throughout the structure lifecycle), a CLO equity holder typically receives annual cash flows of between 16% and 20% of the value of their initial investment in the CLO equity tranche2. These cash flows are the result of the spread arbitrage between the yield of the underlying loan pool and the cost of funding of the CLO3 (Figure 1).
Table 1: CLO management throughout the structure lifecycle
CLO managers are said to build spread when they generate return by increasing the spread arbitrage between the yield of the underlying loan pool and the cost of funding of the CLO.
CLO managers are said to build par when they generate return by purchasing discounted loans which are callable at par.
CLO managers in accordance with CLO equity tranche holders may decide to call a CLO (unwind the CLO structure and terminate the deal) or to proceed to a refinancing of the debt tranches or a reset of the overall structure, after a non-call period of typically two years from its inception.
Figure 1: Illustration of the arbitrage between underlying loan spread and CLO debt
At the end of the amortisation period, the final cash flow would typically represent 45% to 65% of the initial value of the CLO equity tranche, in the absence of any severe market dislocation4. The final cash flows to the equity tranche depend directly on the ability of the CLO manager to avoid defaults in the underlying loan pool and to build par.
Leverage is embedded in the performance of the CLO equity tranches as this tranche, representing a small stake of the CLO structure (at around 9 to 10%), is allocated the result of the arbitrage for the whole structure as well as the full impact of any defaults. The typical leverage – close to 10-fold during the reinvestment period before declining in the amortisation period – may increase the risk of loss associated with credit impairment. It could also reduce the arbitrage spread available to the equity tranche in case of a tightening of loan spreads during the ramp-up period.
Alignment of interest between CLO managers and CLO equity holders CLO managers actively manage and trade the loan collateral to help assure full payment of debt tranches and to enhance equity returns.5
This entails managing the quality of the spread arbitrage, reducing the cost of financing (refinancing/reset) in order to deliver a higher stream of quarterly distributions to CLO equity holders.
Performance-linked fees and the risk-retention rules requiring CLO managers to keep ‘skin in the game’, combine to encourage CLO managers to maximise the return on equity tranches.
1 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 trends are not reliable indicators of future market behaviour. Actual results may vary and the variations may be material.
2 Source: AXA IM estimate in the absence of any severe market dislocation. For illustrative purposes only. This is not a reliable indicator of current or future performance.
3 Cost of the CLO debt, minus the CLO manager fees and other structuring fees/cost (e.g.: trustee)
4 Source: AXA IM estimate assuming the absence of any severe market dislocation. For illustrative purposes only. This is not a reliable indicator of current or future performance.
5 According to analysis by Roberto Liebscher and Thomas Mählmann of the Catholic University of Eichstätt-Ingolstadt, skilled CLO managers successfully serve both debt tranche investors with lower downgrade probabilities and higher over-collateralisation ratios (ie ratio between the principal value of the CLO structures’ underlying corporate loan pool and the total principal value of the notes issued by the various CLO debt tranches) and equity tranche investors with higher cash flows. Source: Creditflux, January 2015.