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The CLO machine is stirring again. Sales of collateralized loan obligations – bonds backed mainly by leveraged buyout debt – are taking off for the first time in Europe since the last crisis. The slicing and dicing of junk debt in CLOs helped inflate the last credit bubble. But the market should broadly welcome the comeback.
CLOs take junk-rated loans and finance them cheaply by issuing highly-rated debt, which is then sliced into differing layers of creditworthiness. The spread between the yield on the junk loans and the funding cost goes to investors who fund the bottom-ranking, equity-like tranche, which typically offers returns of around 15 per cent.
The credit crisis of 2008 turned investors away from structured credit like CLOs. Now, as investors hunt for yield, deals have become viable again. Cairn Capital, a London-based fund manager, has recently sold a €300-million ($403-million) CLO and more are expected. Deals are certainly more expensive than before the crisis; the triple-A-rated bonds pay a spread of 140 basis points over Libor, more than five times the rate in 2007.
The CLOs of old were unnatural beasts. They gobbled up a third of bubbly leveraged buyout loans, and they were funded by risky off-balance sheet banking vehicles rather than mainstream credit investors.
But the new deals look more conservative. In pre-crisis days, rating agencies would ascribe triple-A ratings to as much as 75 per cent of a CLO's funding. The lowest-ranking tranche could be levered over 10 times. In Cairn's deal, the leverage is just fivefold, and rating agencies have given only 60 per cent of the debt their top grade. Investors in that bond would get their money back even if half the loans defaulted and recovered only 20 per cent of par.
Moreover, CLO volumes will be more modest than in the past – banks have shut down the off-balance sheet vehicles that once fed on CLO issuance.
It's tempting to sigh at the return of CLOs. But the reality is that some of them will help companies refinance in coming years. By the end of this year most of the old CLOs will be winding down, and restricted from rolling over loans. Banks are capital-constrained and regulatory rules discourage them from lending to junk-rated borrowers. That leaves a lot a potentially unmet demand.
Welcome, then, reformed CLOs. For once, you are needed more than you are wanted.