CLOs, CDOs and the Search for High Yield

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1 January 2014 CLOs, CDOs and the Search for High Yield Introduction Against a sterile investment landscape, the hunt for alternative sources of yield has become hugely challenging for pension trustees. There are however certain asset classes which are often overlooked by pension schemes which, in certain forms, offer the potential to provide the strong, long term liability matching cash flows highly coveted by pension schemes. One of these, although much maligned during the credit crisis, is Structured Credit. Within this paper we examine the viability of two subsets of Structured Credit; Collateralised Debt Obligations (CDOs) and Collateralised Loan Obligations (CLOs). What exactly are CDOs and CLOs? CDOs and CLOs are a form of Asset Backed Security (an investment linked to the returns and income typically from a pool of other assets to diversify risk). In the case of a CLO the underlying assets are a pool of bank loans and for a CDO, a pool of bonds and mortgages. Under a CLO or CDO the investor earns income in the form of interest payments from these debt instruments and is otherwise subject to the gains and losses on those loans over time as their prices change/and or if defaults occur. CLO/CDOs can also be sliced into tranches and their entitlement to cash flows determined by their seniority ranking. Coupon payments vary by tranche with the most senior holder paid the least and the most junior paid the most, to compensate for the higher risk of default. The examples used within this article are taken from the US where the market for these instruments is perhaps most prevalent. What makes these type of vehicles potentially attractive right now? First of all, credit market fundamentals in the corporate sector are currently very healthy. We need no reminding that the UK government is forging ahead with its austerity measures in a bid to bring the national debt under control. An inevitable side effect of these has been continued sluggish economic growth as endured in many other developed countries such as the US and France. By contrast, company balance sheets and cash flows tend to be strong. This is illustrated in the chart below which shows that interest coverage (a measure of the company s ability to service its debt) is currently at an all time high. Chart SEI For Professional Client Use Only Not for Retail Distribution 1

2 The strong fundamentals of the corporate market are also manifested in default rates which are low in absolute terms and relative to historical averages. This can be seen in the chart below. Chart 2 But what are the specific attractions of bank loans compared to other types of corporate loan? Loans generally trade at significantly wider spreads and higher yields than comparably rated corporate debt. The chart below shows that loans currently offer almost the same yield as high yield (sub-investment grade) bonds (5.5%-6% p.a.), despite their senior ranking in the case of default. Chart SEI For Professional Client Use Only Not for Retail Distribution 2

3 As illustrated in the following chart, they also generally have offered higher recovery rates in the case of a default. Chart 4 But what about liquidity what happened over the financial crisis? Liquidity certainly deteriorated over the financial crisis and this was reflected in the market price of CLOs. However, actual defaults were minimal and price falls within the representative index in 2008 were fully recouped in 2009, as illustrated in the chart below. Chart 5 What are the risks? A primary concern is of course that of default. Chart 2 on page 2 of this paper shows that this has risen to the 8% level twice in the past 15 years; first around the technology bubble and subsequent downturn, and more latterly during the financial crisis of Note however the default has only momentarily reached this level and the long run rate is less than 5%. Moreover chart 4, also shown on page 2, shows that even in default, recoveries have averaged around the 70% level. Actual losses over the long term have therefore been quite small. Chart 2, however, also shows that at the same time the default rate has increased, so has the spread over treasuries. This implies a meaningful capital loss on a mark to market basis. Liquidity has also tended to dry 2014 SEI For Professional Client Use Only Not for Retail Distribution 3

4 up in these conditions and the natural expectation is that this would be also the case in the future. For this reason most providers have official lock up periods and the risk is that these come into force during periods of stress. This is also likely to coincide with a poor equity market environment. In summary therefore, whilst CLOs and CDOs offer high yields with a relatively small risk of permanent capital impairment, they could be included in a part of the overall portfolio which is not expected to offer instant liquidity. What role could these vehicles play in a pension portfolio? CLO/CDO investments can be structured to deliver a range of target yields via creating tranches. A typical range of expected returns p.a. could be 3%-10%. Investments at the low risk/return end of the spectrum share the characteristics of liability matching assets, i.e. they can provide stable, medium/long term cash flows whereas investments at the upper end of the risk/return spectrum can be considered potential return enhancement or growth style assets. Overall, by holding a CLO an investor is exposed to the performance of a portfolio of loans, receiving loan interest while being exposed to loan defaults. However, via tranching of a CLO an investor can also choose to be exposed, for example to the first 10% of defaults on the underlying loans (high risk) or only be impacted should defaults reach 11%-20% (low risk), or 21%-100% (very low risk). In return for taking more/less risk an investor will receive a higher/lower income stream. How can a pension fund access these vehicles? Pension funds who feel that they possess the necessary internal expertise naturally have the option to approach specialist providers in order to access CLO/CDO funds. As with all niche areas, the most appropriate access point will depend on individual circumstances and appetite. Where Pension schemes feel they may lack the requisite knowledge and expertise it may be sensible to talk to an investment manager such as a fiduciary manager/delegated consultant or implemented consultant. A fiduciary manager, such as SEI, may be able to provide specialised advice on an appropriate allocation from your risk budget in addition to helping you identify the most suitable vehicle. Conclusion Trustees of pension schemes should recognise that CLO/CDO investments do not offer instant liquidity. However as a long term investor a pension scheme can typically tolerate a level of illiquidity within the overall investment portfolio that other investors cannot. Despite exhibiting volatility in times of crisis CLO/CDO investments have generally delivered positive and consistent long term returns. And with credit market fundamentals currently strong, historically low default rates and high recovery rates, these investments compare well with other areas of the credit spectrum especially in today s low interest environment. Schemes looking to discover more about CLO/CDO investments may benefit from engaging with an investment expert such as a fiduciary manager. As a fiduciary manager with an extensive heritage in providing and implementing advice that links both assets and liabilities, SEI is optimally positioned to guide pension trustees on the option for their schemes. Contact us For more information us at fiduciarymanagement@seic.com or telephone +44(0) About SEI s Institutional Group SEI s Institutional Group is one of the first and largest global providers of outsourced fiduciary management investment services. The company began offering these services in 1992 and today acts as a fiduciary manager to more than 450 retirements, non-profit and healthcare clients in seven different countries. Through a flexible model designed to help our clients achieve financial goals, we provide asset allocation advice and modelling, investment management, risk monitoring and stress testing, active liability-focused investing and integrated goals-based reporting. For more information visit: SEI For Professional Client Use Only Not for Retail Distribution 4

5 About SEI SEI (NASDAQ:SEIC) is a leading global provider of investment processing, fund processing, and investment management business outsourcing solutions that help corporations, financial institutions, financial advisors, and ultra-high-net-worth families create and manage wealth. As of September 30, 2013, through its subsidiaries and partnerships in which the company has a significant interest, SEI manages or administers $529 billion in mutual fund and pooled or separately managed assets, including $219 billion in assets under management and $310 billion in client assets under administration. For more information, visit Important Information This information is issued by SEI Investments (Europe) Limited ( SIEL ), 4th Floor, Time & Life Building, 1 Bruton Street, London W1J 6TL United Kingdom +44 (0) This document and its contents are directed only at persons who have been categorised by SIEL as a Professional Client, or an Eligible Counterparty, for the purposes of the FCA New Conduct of Business Sourcebook. SIEL is authorised and regulated by the Financial Conduct Authority. This material is not directed to any persons where (by reason of that person s nationality, residence or otherwise) the publication or availability of this material is prohibited. Persons in respect of whom such prohibitions apply must not rely on this information in any respect whatsoever. No offer of any security is made hereby. Whilst considerable care has been taken to ensure the information contained within is accurate and up-to-date, no warranty is given as to the accuracy or completeness of any information and no liability is accepted for any errors or omissions in such information or any action taken on the basis of this information. SIEL is the distributor of the SEI Funds which are authorised in Ireland pursuant to the UCITS regulations and also serves as investment manager and/or fiduciary manager for clients who invest all or a portion of their assets in such Funds. SIEL provides the distribution and placing agency services to the Funds by appointment from its associate, the manager of the Funds, namely SEI Investments Global, Limited, a company incorporated in Ireland ( Manager ). The Manager has in turn appointed another associate, as investment adviser to the Funds, namely SEI Investments Management Corporation ("SIMC"), a US corporation organised under the laws of Delaware and overseen by the US federal securities regulator. SIMC provides investment management and advisory services to the Funds. Any reference in this document to any SEI Funds should not be construed as a recommendation to buy or sell these securities or to engage in any related investment management services. Recipients of this information who intend to apply for shares in any SEI Fund are reminded that any such application must be made solely on the basis of the information contained in the Prospectus (which includes a schedule of fees and charges and maximum commission available). Commissions and incentives may be paid and if so, would be included in the overall costs. A copy of the Prospectus can be obtained by contacting your Financial Advisor, SEI Relationship Manager or by using the contact details shown below. Past performance is not a guarantee of future performance. Investments in SEI Funds are generally medium to long term investments. The value of an investment and any income from it can go down as well as up. Fluctuations or movements in exchange rates may cause the value of underlying internal investments to go up or down. Investors may not get back the original amount invested. SEI Funds may use derivative instruments which may be used for hedging purposes and/or investment purposes. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events. With respect to bank loans, an investor will assume the credit risk of both the borrower and the lender that is selling the participation in the loan. The investor may also have difficulty disposing of bank loans because, in certain cases, the market for such instruments is not highly liquid. Bonds and bond funds generally decrease in value as interest rates rise. They are subject to prepayment and extension risk and therefore react differently to changes in interest rates than other bonds SEI For Professional Client Use Only Not for Retail Distribution 5