BARINGS CONVERSATIONS February 2019

Transcription

1 BARINGS CONVERSATIONS February 2019 CLOS & LEVERAGED LOANS: BENEATH THE HEADLINES This piece was adapted from an interview with Matt Natcharian and Adrienne Butler. The full audio podcast can be found here.* WITH THE RECENT BOUT OF MARKET VOLATILITY, AND QUESTION MARKS MATT NATCHARIAN, CFA HEAD OF BARINGS STRUCTURED CREDIT ADRIENNE BUTLER HEAD OF BARINGS U.S.-MANAGED CLO FUNDS AROUND WHERE WE ARE IN THE CREDIT CYCLE AND WHEN THE NEXT ECONOMIC DOWNTURN MAY HIT, INVESTORS ARE RIGHTLY ASKING WHAT IT ALL MEANS FOR CLOS AND LEVERAGED LOANS. IN THIS Q&A, BARINGS HEAD OF STRUCTURED CREDIT, MATT NATCHARIAN, AND HEAD OF U.S.- MANAGED CLO FUNDS, ADRIENNE BUTLER, ADDRESS THE PRESSURES FACING THE LEVERAGED LOAN AND CLO MARKETS TODAY. Recently, there has been a lot of negative press surrounding leveraged loans and, by extension, CLOs. In some cases, we ve seen comparisons between today s market and the period preceding the global financial crisis. How much of that is warranted, and is it a fair comparison? MATT: I d like to start by making the point which you often don t see in a lot of news articles that a Collateralized Loan Obligation (CLO) securitization is actively managed by a professional institutional credit manager that s an expert in buying and managing large corporate loans. Most securitizations, like those containing auto loans or mortgages, are just pools of similar assets that are packaged and analyzed statistically. But here you have credit analysts at well over 100 institutional asset managers that have issued and managed CLOs. They re picking the individual loans, building a diversified corporate portfolio and then actively managing it for a period of five or so years. ADRIENNE: What you also tend not to see in the press is that CLOs are backed by a diverse pool of senior secured loans, which are senior to other outstanding debt in an issuing company s capital structure. This seniority means that the loans interest and principal payments must be paid before other creditors receive payment. The loans are also secured, usually by assets or stock of the company, which can provide investors with additional credit risk protection and increased recovery in the event of a default. Additionally, the loans that make up CLOs typically come from issuers that would be familiar to most institutional investors like Dell, First Data or Charter Communications. And the loans themselves tend to be very diverse Moody s breaks them up into 35 different industry sectors, which means an investor can benefit from a high level of diversity by investing in them. *Full podcast URL: 1

2 MATT: I think that s an important point. While individual CLOs vary in their exact level of diversity, all of them even the ones with the most concentrated risks are still very diversified by industry and issuer. So, when Adrienne builds a portfolio of CLOs, she is working to give investors exposure to the best ideas that Barings high yield research team is finding in the market. Then, when my team and I are constructing portfolios of CLOs, we are also allocating across a variety of third-party manager CLOs that represent the best ideas of each of those managers as well. In the high yield market, in general, there will be individual-name defaults in almost every manager s portfolio somewhere along the line. But by building a diverse portfolio of CLO investments, you end up with ultra-diversified exposure to the corporate loan market. ADRIENNE: That said, the volatility that we ve seen in the market does create angst among investors. But it s important to keep in mind some key differences between today s market and For one, the loan market has evolved a lot since the financial crisis. Today, it s over $1.2 trillion in size, whereas it was half of that in So, in terms of its robustness, its ability to trade and the number of investors involved, it is a far more mature market than it was at that time period. Additionally, leading up to the crisis, we saw much higher leverage and lower interest coverage than we re seeing today, which suggests that today s market is healthier than it was leading up to the crisis. It s also worth mentioning that senior secured loan defaults have averaged just over 2% annually since What my team does on a day-to-day basis is assess the relative value of the underlying securities the senior secured loans. We analyze the fundamentals of each individual investment, carefully monitoring metrics like leverage, interest coverage, collateral and enterprise value. At the end of the day, we believe this bottom-up assessment is the most important aspect of risk mitigation in the portfolio. U.S. LOAN DEFAULT HISTORY (%) 10% 9.57% 8% 6% 4% 2.91% 3.01% 2.54% MARKET AVERAGE = 2.40% 2% 1.87% 1.45% 1.60% 2.10% 1.60% 1.25% 0.23% 0.72% 0% SOURCE: CREDIT SUISSE LEVERAGED FINANCE STRATEGY UPDATE. AS OF DECEMBER 31, 2018 (TRAILING 12 MONTHS). DEFAULTED LOANS DEFINED AS MISSED COUPON, CHAPTER 11 FILING, DISTRESSED EXCHANGE, OR CROSS-DEFAULTS. 2

3 CLOS OFFER INVESTORS A RANGE OF RISK/RETURN PROFILES lowest risk CORPORATE CAPITAL STRUCTURE CLO ASSET COLLATERAL POOL CLO DEBT AND EQUITY TRANCHES Senior Secured Loans Unsecured Debt Equity selected loans senior secured bank loans Actively managed Diversified across industries Average credit rating: B1/B2 cash flows AAA (60 63%)* AA (10 13%) A (7 9%) BBB (4 6%) BB (4 6%) B (1 2%) highest risk EQUITY (8 10%) *TYPICAL PERCENTAGE OF THE CLO STRUCTURE REPRESENTED BY TRANCHE. FOR ILLUSTRATIVE PURPOSES ONLY. Poor documentation, if not fraudulent documentation on a subprime mortgage, is very different than a loan to Dell. Building on that, can you touch on what separates CLOs from the CDOs that were prevalent during the financial crisis? What are the differences from a risk perspective? And as we think about a possible downturn, what is your sense for the robustness of CLO structures? MATT: Whereas a CLO focuses on loans, a Collateralized Debt Obligation (CDO) can focus on any kind of debt. In 2008, the subprime mortgage debt market played a major role in the collapse, due to pools of faultily underwritten subprime mortgages. Poor documentation, if not fraudulent documentation on a subprime mortgage, is very different than a loan to Dell, as an example. Those are two very different risks and that s the fundamental difference between the CDO market and the CLO market, even though they share some similarities in terms of how interest and principal cash flows are divided up. In terms of robustness, it s also important to point out that these are not new structures. CLOs have been around for a long time, really since the mid-1990s. And over that 20+ year period, we ve gone through multiple credit cycles and events, including the global financial crisis. With each year and each cycle, improvements have been made to the CLO structures based on past experience. The universe of credit managers that serve as collateral managers for CLOs has also gotten more robust. Not to mention, as you go back through history, CLO performance has been strong. And one of the reasons, as Adrienne pointed out, is that senior secured loans, the underlying collateral, are at the top of the capital structure. As a result, in the event of default, these loans have historically offered high recovery rates relative to other types of debt investments. Additionally, CLOs because of the longer life of the structures give you more spread duration. So, you can potentially make higher returns when spreads tighten. But you can also express that defensively. A large global bank or insurance company that needs to buy very high quality assets might buy the triple-a tranche of a CLO and they ll get about 32% of the spread available on that loan portfolio, which is yielding about LIBOR plus 125 basis points, depending on the manager and particular deal. Plus, they can handle all of the loans in a diverse portfolio defaulting and still recover all of their money. 3

4 HISTORICAL DEFAULT RECOVERY RATES ACROSS TRANCHES Current Historical Average Annual Low Rolling 5-Year Low Recovery Rate 81.3% % % 2 (1993) 64.3% 2 ( ) 1. SOURCE: MOODY S ULTIMATE RECOVERY RATE. AS OF DECEMBER 31, HISTORICAL DATA DATES BACK TO THE ULTIMATE RECOVERY IS DEFINED AS THE PRESENT VALUE OF THE CASH OR SECURITIES THAT CREDITORS ACTUALLY RECEIVE WHEN THE ISSUER EXITS BANKRUPTCY. 2. SOURCE: MOODY S 1ST LIEN BANK LOAN RECOVERY RATE. AS OF DECEMBER 31, ADRIENNE: As we think about risk, it s also worth mentioning that post-crisis regulations like the Volcker Rule and Dodd-Frank have had an impact and created stability within the loan market overall. The fundamental system is sounder than it was prior to their implementation, in our view. CLO CUMULATIVE RETURNS (%) 160% 120% CUMULATIVE RETURN (%) 100% 80% 60% 40% 20% 0% Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 Dec-17 Jun-18 Dec-18 CLO AAA CLO AA CLO A CLO BBB CLO BB AAA AA A BBB BB Cumulative Return 18.52% 33.54% 49.89% 78.52% % Annualized Return 2.46% 4.22% 5.95% 8.63% 12.01% Standard Deviation 0.87% 2.18% 3.45% 6.22% 9.92% SOURCE: JP MORGAN CLOIE TOTAL RETURN INDEX, SINCE INCEPTION. AS OF DECEMBER 31, PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. As you think about your outlook for 2019 and beyond, what are some of the main takeaways? ADRIENNE: Thinking about our entire conversation here, the CLO market is very large, robust, liquid and diverse. As I mentioned earlier, the underlying loans are both senior (higher up in the capital structure) and secured (backed by some or all of a borrower s assets). 4

5 As a result, in the event of an issuer default, the loans have historically offered high recovery rates relative to junior debt instruments with a 30-year average of 80%. While I think the market expects recovery values to be somewhat lower in the current environment, it all comes down to managing the default rates and picking the right credits. All of that said, as we look ahead to what may be a choppy 2019, we believe CLOs will continue to provide an efficient way to gain exposure to the senior secured loan market. MATT: We started out talking about the negative press that s been in the market lately, and that may persist through the remainder of the year. But as we think about investing in CLOs in the near to medium term, there are a few important takeaways that come to mind. For one, as somebody who has been in this market for a long time, and seen a lot of different ups and downs, what s really stood out to me is the importance of diversification and active management by professional credit investors. In addition, while the CLO market is a bit complex, if you do the work to get comfortable with it and study how well it has performed through multiple credit cycles, it can be very rewarding. There are a lot of different ways to express interest in this sector and work toward achieving your portfolio goals. MATT NATCHARIAN, CFA HEAD OF BARINGS STRUCTURED CREDIT Matthew Natcharian is Head of Barings Structured Credit Investment Group and a member of the firm s Global Strategy Committee. He actively participates in the portfolio management of all structured credit focused portfolios and is responsible for structured credit investments, primarily in collateralized loan obligations. Matthew has worked in the industry since 1995 and his experience has encompassed CLOs and securitized corporate credit, including synthetic credit products. He has served as a Director of Invicta Capital LLC, a credit derivative product company, from 2008 through 2014, and was responsible for the credit underwriting and monitoring of the credit portfolio. Prior to joining the firm in 1995, he worked at both Allmerica Financial and New England Mutual Life. Matthew holds a B.S. in Finance from Bentley University and is a member of the CFA Institute. ADRIENNE BUTLER HEAD OF U.S.-MANAGED CLO FUNDS Adrienne Butler is a member of Barings U.S. High Yield Investments Group and is head of CLO Funds. She is also a member of the U.S. High Yield Investment Committee. She is responsible for new CLO marketing and formation as well as existing CLO portfolio management. Adrienne has worked in the industry since 1990 and her experience has encompassed sell-side relationship banking, media and telecom specialty lending, and CLO portfolio management. Prior to joining the firm in 2002, she was part of the acquisition of First Union Institutional Debt Management ( IDM ), where she was a senior analyst in IDM s Loan Research Group. Before IDM, she was a vice president/relationship manager at First Union Corporation and worked in corporate banking at First Union National Bank of South Carolina. She also served as a loan officer at NationsBank. Adrienne holds a B.A. from Furman University and an M.B.A. from University of Notre Dame s Mendoza College of Business. 5

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