Collateralised loan obligations – a risky bet on inflation

For someone who likes adventurous ideas, I must admit I’m nervous mentioning collateralised loan obligations (CLOs) in a publication aimed at private investors. These securities are complex, they can be volatile and they are largely held by institutions. They are a high-risk, high-return investment that is the first to get burnt in a crisis.

However, for the most part CLOs have survived the global financial crisis (GFC) and the pandemic intact, and have gone on to prosper. If you understand the risks and want a robust income in this inflationary environment, listed CLO funds could be worth exploring.

Slicing up risk

CLOs are bundled-up loans that allow investors to buy corporate credit risk, largely through senior loan portfolios structured into several debt tranches plus a bottom layer of equity. Different debt tranches have varying risk and return profiles with different credit ratings based on their levels of security and bankruptcy risk. The AAA tranche usually makes up around 60% of the capital structure. The higher-risk equity tranche generally comprises about 10%.

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The AAA-rated layer tends to return slightly more than cash. Returns increase for the less senior elements and junior debt tranches, which have yields similar to high-yield junk bonds.

CLO tranches have generally provided better risk-adjusted returns than comparable bonds, reckons Joachim Klement, a strategist at investment bank Liberium. That’s been true even in a crisis. The pandemic showed the new generation of post-GFC structures – with more buffers and some better protections – outperformed expectations. Over the past two years, the distribution to equity tranche investors in US CLOs never dropped below 10% per annum. On average, investors in CLO equity tranches earn an annual premium over the S&P 500 of 0.4% after fees.

Coping with inflation

There are a handful of London-listed CLO funds: Blackstone Loan Financing (LSE: BGLF), Chenavari Toro Income (LSE: TORO), EJF Investments (LSE: EJFI), Fair Oaks Income (LSE: FAIR), Marble Point Loan Financing (LSE: MPLF) and Volta Finance (LSE: VTA). These have CLO exposure ranging from around 70% of the portfolio (the rest is in other speciality finance) to 100%. Yields range from 8% to 15%.

Returns have been strong – ie, Fair Oak reported returns to net asset value of 22.71% in 2021 compared to 5.46% for the JPMorgan Leveraged Loan index and 6% for the JPMorgan High Yield index. Investors seem to be buying into CLOs as inflation increases, pushing up the value of the assets these funds hold. That’s backed up by data showing that US loan funds have seen their highest monthly inflows since 2012, say analysts at Numis.

One crucial point concerning inflation is that CLOs can include floating-rate loans. If central banks raise rates to tackle inflation, the rate that these loans pay will increase. The fact that CLOs are high-yield debt should also help them cope better in an inflationary enviroment than government bonds or high grade corporate bonds, says Liberium’s Klement.

Of course, if inflation is too high and rates go up in response, that could provoke a recession. This might in turn cause more corporates to default, in which case equity tranches – favoured by many of the CLO funds – might get hit badly. Still, defaults currently don’t look too scary. The trailing 12-month default rate is 0.29% in the US and 0.62% in Europe (although the distressed ratio – the percentage of loans trading below 80 cents on the dollar – has ticked up lately).

This could change rapidly. It is vital to note that investing in CLO funds is high risk. Still, if the funds keep providing returns in the 10%-20% range (most of that in dividends) as they have done, then a bad year (or two) might be worth it to get access to the extra returns from all that financial engineering.