Unlocking markets: the CLO 2.0 era

Unlocking markets: the CLO 2.0 era

by Mark Shohet, Portfolio Manager for Securitised Credit and CLO management, and Mike Reed, Head of Global Financial Institutions.

Mike Reed 00:04

Hello, and welcome back to Unlocking Markets, the RBC BlueBay podcast, where we bring you experts from across our firm, providing opinions on markets, global policy, and macroeconomics, whilst highlighting how these feed into our investment decisions. I'm Mike Reed, Head of Global Financial Institutions. Today, I'm delighted to welcome Mark Shohet, who is portfolio manager in the securitised credit team here at RBC BlueBay.

Collateralised Loan Obligations, CLOs, are a somewhat unique product that allow investors to purchase an interest in a diversified portfolio of company loans, thus spreading their risk. Over recent months, we have seen an increase in investor interest in these products, as clients are attracted by the potentially higher than average returns available. I think it's fair to say that this area of finance is somewhat misunderstood by many, so I'm very pleased to welcome Mark to the podcast to explain what has generated the recent increase in interest in CLOs, and what are the various ways that clients are getting involved. Welcome, Mark.

Mark Shohet 01:04

Hi, Mike. Great to be here with you.

Mike Reed 01:06

Thanks for coming on the show. Mark, let's kick off. Let's start with the basics, because CLOs, as I touched on, are considered a somewhat complex asset class. I tried to give a brief introduction, but how would you explain what a CLO is, for those that are less familiar?

Mark Shohet 01:23

Yes, Mike, thanks for the question. I would start by defining a CLO. As you said, it's a collateralised loan obligation. It's essentially just one type of financial product within the larger securitised credit asset class. Quite simply, it's a vehicle that contains assets and liabilities. The assets are a pool of diverse, below investment grade corporate loans that are purchased by the CLO vehicle. That forms the collateral. The liabilities are floating rate debt instruments or bonds that are sold off to investors, in order to finance the purchase of those assets. Each of these liabilities is called the tranche. Each of these tranches has different ratings and different varying degrees of return and risk.

Then this CLO vehicle is actively managed by a CLO manager. The residual value between the assets and the liabilities and the fees that go to the manager goes to the equity holders of the CLO. You can think of a CLO as a mini bank. It holds assets, which is the leveraged loans, it pays off its creditors, and it aims to profit from the excess spread between the two in order to maximise the residual value for shareholders, or in the case of a CLO, to the equity tranche holders.

What is unique to the CLOs is that the pool of assets can be traded for four to five years, typically, this is known as the reinvestment period, before which time the CLO begins to wind down and the CLO debt tranches will amortise. The whole purpose of a CLO is to take advantage of the funding gap between the asset spreads, which is the loan spreads, typically in the low 300s to mid 300s, depending on the market environment, and the liability costs on those CLO tranches I talked about. This is known as the CLO arbitrage. This is why CLOs are created.

The tranches get rated AAA to equity based on the amount of exposure they have to losses in the underlying pool, and where they sit in the priority of payments. For example, the AAA tranche is paid first and has the most protection from losses. At the bottom of the capital structure, the equity tranche is paid last and has first exposure to losses in the collateral pool. This is essentially how a CLO works. It's an asset class that stands at about USD1.4 trillion in size today between the US and Europe. The CLO tranches themselves are liquid instruments that are rated and they trade daily over the counter. And the last thing I'd point out is that CLO vehicles are a very important part of the loan ecosystem, as they represent over 70% of the buyer base for loans.

Mike Reed 04:10

I like that analogy that a CLO is like a bank. It's a really good visualisation from the AAA, so it was like secured deposit, and I know that’s not secure, but that higher level down to the equity return that the shareholders are trying to get. I like that's a great visualisation.

Moving on, CLOs are essentially, as you say, giving investors exposure to leveraged loans. What are the benefits of investing in a CLO or the tranches versus just directly investing in the loan market?

Mark Shohet 04:44

I think the most interesting or beneficial aspect of investing in CLOs versus loans is that investors can get access to their desired spread, depending on where they play in the capital structure within the CLO. The opportunity exists because the weight average liability costs on all of the CLO tranches is somewhere around 170-180bps in today's market. The CLO AAA tranche, which is the most safe tranche in the capital structure and the most highly rated tranche, that makes up 65% of the capital structure. In today's market, that's about 130bps. To get to that weighted average of 170, 180, that means your mezzanine tranches, or even your tranches in the middle of the capital structure, are quite a fair bit wider. As an example, in today's market, you can buy CLO BBBs in the 300 spread, CLO BBs in the 500s or 600s.

This creates enormous opportunities for investors to travel up and down the rating and the risk spectrum where they can easily stay exposed to the same master class. Even within the same CLO structure, they can get varying degrees of risk and return by just choosing where they want to play in the capital structure.

I would say this is the key benefit of investing in CLOs versus loans directly, because there's something for everyone no matter your risk appetite or your spread target. This is why we see the top of the capital structure in AAAs and double AAs. This is typically purchased by banks, insurers, pension funds. Middle of the capital structure, so call it your single As, the BBBs, these are a little bit wider spread, a little bit more spread duration. These are purchased by asset managers and credit funds. And then your mezzanine tranches, so your BBs, single Bs, and your equity tranches, these, of course, are going to be played in by credit funds, hedge funds, and BDCs. So, a lot of variety within the CLO capital structure where you can get exposures and ratings that are very different than what you would get in loans while still being exposed to the loan asset class.

Secondly, the diversification element of CLOs and structured credit in general is very powerful. As I mentioned before, the collateral consists of a pool of loans. Typically, each CLO consists of 300 to 500 individual loans. Sometimes it's more. What this does is this removes single-name obligor risk from the CLO investor. No individual loan makes up more than about 50bps of risk. As a CLO investor, you don't need to worry about single-name or idiosyncratic stories in the same way you would if you were buying individual loans.

Then lastly, of course, the higher spread and higher yields that are available in CLOs versus loans are very attractive. CLO BBs are currently in the 500s to 600s spread in the primary market. That compares to BB-rated loans, depending on if you're looking at US or Europe; US is a little bit tighter, probably more like 200s to 300s, Europe is more like 300s. That's lower spread than the CLO BB-rated CLO. Even single B loans are in the mid 400s, which are tighter than CLO BBs.

Then within the CLO BBB part of the capital structure, those are in the 300s like I mentioned, which is great IG-rated risk. If you compare it to where loans and high-yield spreads are, you'd really need to go into the sub-IG part of the capital structure to get the equivalent spread in loans.

In summary, I think you get really interesting return profiles and really good and attractive risk-adjusted diversified returns that makes, in my opinion, CLOs interesting and beneficial to investing versus loans.

Mike Reed 08:59

I get the diversification aspects there and how that can be attractive and limiting exposure to individual issues etc, and idiosyncratic risk, and the wider spreads. But frankly, these have existed for a period of time. Why do you think today investors are getting more interested than they have been for a number of years, I would say, in this asset class?

Mark Shohet 09:30

It's a good question, and something we talk a lot about with our investors. We live in uncertain times, whether it's tariffs, whether it's the impact of DOGE, whether it's political turmoil at home or abroad, and a range of geopolitical questions. These are questions that entire industries are facing right now. If you look at, for example, the case of autos or building product companies, the impact of policy can have massive impact on their earnings potential. In this current environment of heightened volatility and uncertainty, the diversification element of CLOs, which I keep coming back to, is extremely valuable and extremely worthwhile for investors to consider.

If you're investing in a CLO tranche, you don't need to worry in the same way about idiosyncratic stories because you have the diversification element of the CLO, and you have the additional credit enhancement from the CLO vehicle that's protecting you in the case of few loans that go sideways. CLOs are also a very low interest rate duration product because they pay floating rate coupons. An environment where Fed policy and interest rates are very uncertain, that's very valuable to a lot of our investors. With all of these benefits, you're still getting attractive spreads versus corporates.

I think that's the reason why there's been a fair amount of interest in the asset class, both continued interest and new interest. We're actually seeing a lot of traditionally mezz and equity players that are playing in the IG part of the CLO capital stack because the returns are still interesting there and they're waiting it out there for some of the uncertainties to subside. I think these are all contributing to CLOs gaining a lot of attraction in the last couple of years.

I'd also say that CLOs have become much more liquid and a much bigger asset class. They're very straightforward to sell or to source large amounts of risk on any given day. It's an asset class that's not just niche or hypothetical like it may have been in the past, but it's currently very sourceable and proven. I think this is relevant for investors today since they have so many asset classes to choose from and there's so much newsflow that's changing weekly, if not daily. Investors, they want to be confident that they'll be able to rotate quickly out of their positions if there's a change in view, and I think CLOs provide the opportunity to do that.

Mike Reed 12:08

I guess you're talking about a USD1.4 trillion market, as you say. Liquidity is going to be good. Those are the dynamics there I can see. Let's take a step back a little bit. We can't really talk about CLOs without talking about the elephant in the room, which is obviously 2008. A lot of investors still bring that up when I'm in conversation with them. That was a major time for CLOs and structured product markets. How has the market changed over the subsequent two decades? What's improved there?

Mark Shohet 12:45

I'll start with a point of clarification, which is the fact that the collateralised debt obligations that contributed, at least partly, to the GFC were very low quality and were very highly correlated to the subprime housing market. It was very sensitive to one sector of the economy, which was housing. CLOs are and always have been diversified pools of corporate debt. Therefore they're sensitive to corporate health. It's a totally different asset class. We always joke around that a CLO has a C and an O. It looks and sounds like a CDO, but a CLO is definitely not a CDO. Therefore, the asset class is very different.

Even within CLOs, if you just look at CLOs today versus pre-GFC, and we put a dividing line at 2012, which is when the so-called CLO 2.0 era began, even since then, the asset class has come a long way. For starters, back before 2008, this was a USD200 billion, USD250 billion asset class. Today it's over USD1 trillion, like I said. It's a little over USD1 trillion in the US and it's about USD1.4 trillion if we include Europe. Much, much bigger and much more mature asset class. The CLO vehicles are much more structurally robust today. They come with higher over-collateralisation ratios or credit enhancement on each tranche.

The collateral that's allowed is much more stringent. There's less bonds that are allowed. Some of the pre-GFC structures allow for other structured credit investments that's typically no longer allowed. The documents are much more debt friendly. Due to all these factors, we've seen much more broad-based investor support within the asset class. It's definitely changed from something being a niche asset class to a much larger and much more mature asset class today. It's grown in size and scale, it’s provided better structural protections, and it's had a very long period of time to prove and provide its resiliency.

One thing I'll add, Mike, is that in the 2.0 CLO era, that's from post-GFC, no investment grade CLO tranche has taken a default. Even on the BB tranche, less than half a percent have taken a default. That's outstanding performance versus corps of the same or even higher rating. It's the reason why I think CLOs have been able to prove their resiliency and are getting the interest they are today, despite some of the noise of 2008.

Mike Reed 15:33

It definitely sounds like there's been some evolution since 2008. Good to point out the difference between a CDO and a CLO, because I still think people get…they put them in the same bucket. Obviously, they’ve performed well. You're getting greater returns, definitely on paper in terms of spread. But I've always been taught greater returns, there's greater risk involved there. I'd like to just take a minute just to focus on some of the downsides. Where do you think the downside risk lies in this product or in the markets at this point in time? What could harm returns?

Mark Shohet 16:12

I don't think it'll be anything within the CLO ecosystem or within CLO vehicles or tranches. I think the downside will be broad-based macro moves, whether it's in stocks, whether it's in rates, whether it's a change in view or perspective or flows from asset managers. I think CLOs typically do lag those moves, but if they persist for long enough, we will start seeing broad-based beta-driven moves. I think that's something we will be able to avoid, so our asset class will move in sympathy.

Short of that, I don't see anything within our asset class to really provide a downside because, like I said, the asset class has matured, investor support is broad-based, and because, again, of the diversification element within CLOs, even if you have multiple loans or bonds that have these single-name idiosyncratic stories, it won't be enough to move the needle, particularly on the IG part of the capital structure within CLOs.

Mike Reed 17:25

That's reassuring to hear. Thank you for that. There's clearly a lot to consider as a CLO investor. What do you think gives us, I say us, I mean RBC BlueBay and you and your team, an edge in this space?

Mark Shohet 17:40

As a bit of background, we manage over USD8.5 billion in securitized credit. That's funds that invest across CLOs as well as other types of securitised assets such as RMBS and ABS. We invest up and down the capital structure from AAA down to equity. We invest across geographies, so we can be very flexible. This forces us to constantly re-evaluate which asset classes and sub-markets within structured credit provide the best relative value. I think it gives us an edge versus peers that perhaps only focus on one or two areas of the market, or maybe only one area or one end of the rating spectrum.

On the CLO tranche investing side, we invest both in Euro and US CLOs. We can invest in primary or secondary. We're not limited to one or the other like some other asset managers may be. We always go to where the best opportunity is.

We're also CLO managers. We issue our own CLO vehicles, in both the US and Europe. We actually just recently priced our 10th CLO vehicle. This benefits us in a couple of ways. The most obvious of which is we have great insight into the underlying credit stories and names within CLO vehicles. That's particularly beneficial to us when we're investing deeper in the capital structure because these are names that our CLO PMs see every day and have a very strong opinion on. So, we can consult with them and learn more as we need to, depending on where in the capital structure we're investing.

Secondly, this benefits us because when we're marketing a deal, we have great insight through the syndication process into the depth and the appetite for our CLO debt and equity tranches. We're understanding the dynamics of which types of accounts are participating in primary transactions. This can really help us, and then we can apply this to our CLO third-party tranche investing efforts.

Another part of our success is that our team is very nicely placed, because while we're the specialist in securitised credit, we work alongside our CLO management PMs and our leveraged finance PMs, who we lean on for the fundamental credit expertise, and we work alongside our macro specialists who help us form our macro overlay views to determine, for example, if now is a good time to dial up the risk or dial back risk based on what they're seeing with the broader macro trends. We incorporate all of this, all of these views into our investment decision-making.

Of course, finally, we're a global team. As you can tell by my accent, I'm located in the US. We have several team members in London. We have coverage throughout the day. Because we speak all day and we work so seamlessly, dealers know this. They know they can always find one of us anytime either the US or Euro market is open. This has actually benefited us in many ways. Many times, we're the first call for interesting opportunities because of our availability throughout the day.

In summary, I would say we don't think of ourselves as simply CLO tranche investors or even broad-based securitised credit specialists. Instead, given all of the tools at our disposal, we really consider ourselves as well-rounded investors. If I put all this together, I'd say our platform, our CLO management business, our team expertise and experience, as well as our rigorous credit underwriting, really gives us an edge in what's certainly a competitive market. It's what's enabled us to deliver best-in-class performance to our investors.

Mike Reed 21:28

Thanks for that. I would guess Information is key. You've got so many data points to help you with your investing there that it's clear how you can get an advantage there. Anyway, thank you, Mark. It was great to get such a better understanding of the CLO market. It's obviously an area of finance that is of considerably growing interest to our clients, based on the number of inquiries and investments that's going on. You explained the opportunities that exist, and helping address some of the legacy concerns was very interesting and very helpful.

Mark Shohet 22:01

It was great to be here with you. I'm glad we were able to have a conversation on CLOs.

Mike Reed 22:07

Great. Having a transatlantic conversation was really great. Many thanks for listening to the show. If you've enjoyed it, please like and subscribe on your podcast platform of choice. Next time on the show, we'll be joined by Marc Stacey from our investment grade team. Core rates are now elevated after spending nearly a decade at near-zero levels, and investors appear to be increasing their fixed income exposure within their portfolio. I look forward to hearing Marc's update on current trends and opportunities.

If you wish to listen to any of the previous editions of the Unlocking Markets podcast, they are available on our website, www.bluebay.com, or can be found on Apple, Spotify, or Google. Thank you once again for joining us today. Good luck and goodbye.