Liquid Credit Market Snapshot: The Resilience of CLOs
The collateralized loan obligation (CLO) market is approaching $1 trillion in size, having more than doubled in the years following the global financial crisis. Largely due to their increased popularity, CLOs have drawn criticism from observers who argued they would trigger the next downturn as a result of a wave of defaults by companies with overly aggressive loans. Instead, the next downturn was caused by COVID-19, an external shock almost no one saw coming which put significant pressure on credit markets.
Despite this dislocation, however, the CLO market has demonstrated resilience throughout the global pandemic. Given CLOs’ continued strong performance, we believe investor demand will increase, in particular as companies grow sales and earnings, defaults remain low and credit ratings continue to improve. This environment has created a situation in which CLO liabilities are tighter and assets are wider than they were prior to the pandemic, setting up a favorable environment for CLO investors.
Lauren Basmadjian, our Co-Head of Liquid Credit and Head of US Loans & Structured Credit, shares insights that help explain the evolution of the market, examines the drivers of record levels of activity and strong performance in the current environment and offers her perspective into what the future may hold for the CLO market.
CLO Market Evolution and Expansion
CLOs seek to provide portfolio diversification by exposing investors to pools of predominantly first-lien loans issued by large companies rated below investment grade across multiple sectors. These structures have historically provided equity holders consistent low- to mid-teen rates of return through high-yielding, floating-rate securities. In fact, since the early 2000s, the vast majority of CLOs have delivered positive returns, with more than 50% generating more than 15% returns to the equity holders.
Largely as a result of their consistent performance, the CLO market is approaching $1 trillion, having more than doubled in size and prominence since the financial crisis, an event that marked the first critical test of the structure’s resilience. The strong performance of the asset class in the wake of the crisis has driven the market’s significant, sustained growth in the decade-plus since. CLOs are designed to benefit from multiple layers of protection during periods of volatility, enabling the market to remain resilient across economic cycles. General structure requirements mandate that portfolios must be concentrated in senior secured loans with high sector and borrower diversity. Meanwhile, active portfolio management and in-depth credit analysis by highly skilled investment managers are key to generating value for investors.
Weathering an Unprecedented Storm
Leading up to the COVID-19 pandemic, many analysts believed that the CLO market grew too much, too fast and had approached “bubble” status. Observers predicted that a wave of defaults among companies who received overly aggressive loans from the CLO market would cause the next significant economic downturn. Yet what caused the next dislocation would be something almost no one had predicted: a global pandemic that forced global lockdowns, slowing business activity and putting pressure on credit markets. As downgrades surged, CLO portfolios saw credit ratings drop and many managers repositioned their portfolios to reduce default risk. For example, Carlyle traded approximately $11.8 billion (or 64% of existing AUM) of its positions in the U.S. in 2020 by quickly assessing risk for each credit and then expressing that view by trading.
Today, as the global economic recovery strengthens, the leveraged loan default rate is down to its lowest level since December 2019 according to the S&P/LSTA Leveraged Loan Index. The weakest companies went bankrupt and many of those that survived reduced costs significantly. As a result, many companies have grown both revenue and EBITDA and are in the midst of upgrades by credit rating agencies. In the backdrop of improving credit quality, many loans are still trading below par given the high volume that have come to market.
“CLOs have performed as expected throughout the current crisis, helping to stabilize corporate credit markets and meet the needs of below investment grade borrowers while maintaining the potential to pay higher equity returns.” - Lauren Basmadjian, Co-Head of Liquid Credit and Head of US Loans & Structured Credit
Maintaining Strong Performance Over Time
We believe CLOs are in the beginning of a new cycle of expansion and are in a stronger position today than before the onset of COVID-19. CLO liabilities are tighter and assets are wider than pre-COVID, which we believe sets up better arbitrage opportunities. In the near term, we believe 2021 will be one of the most active years for CLO issuance.
CLOs have historically benefited from the current backdrop of strong GDP growth and acceleration of business activity across most industries, and we anticipate continued business deleveraging, upgrades and low defaults.