“Euro CLOs offer healthy returns”


Many investors have long viewed European Secured Loan Bonds (CLOs) as a niche of the bond market worthy of little attention. However, given that this asset class has traditionally offered both a high degree of inflation protection, strong credit performance, and a large spread premium over more traditional fixed income assets, we believe that ‘it can no longer be ignored.

For the uninitiated, these CLOs are bond instruments backed by various pools of loans to companies, typically in different sectors, across Europe. Bonds are divided into tranches which may have different ratings (and yields) depending on their rank in the CLO’s capital structure, normally AAA ratings at the top to equity ratings at the bottom.

CLOs typically have a number of characteristics that can be attractive to bond investors, especially given the macroeconomic backdrop we are experiencing as economies reopen following Covid-19 closures.

More importantly, European CLO bonds are predominantly floating rate, which helps protect holders from the corrosive impact of rising interest rates at a time when strong inflation data increases the prospect of rising interest rates. rate by central banks.

For a more traditional bond portfolio, CLOs are typically used to provide welcome diversification and hedge against inflation.

However, the case of CLOs does not end with inflation.

CLO’s European offering increased sharply during 2021, with volumes reaching € 68bn, including € 47bn in refinancing operations and € 21bn in new issues. This glut has caused AAA spreads to drift up to around 130 basis points this year, well above any other AAA-rated asset class found on the market today.

In addition, credit metrics in CLO’s European transaction-backed portfolios have rapidly improved from the low of the Covid-19 crisis and returned to levels we saw before the pandemic; the proportion of assets traded below a spot price of 80 in the leveraged, high yield loan markets returned to its pre-Covid level of just 0.3% by month-end ‘August. Given the low level of stressed loans, we expect defaults to remain low and CLO credit performance to continue.

The specialized nature of European CLOs also means that they have always offered investors a premium over bonds of similar rating, and this remains the case today. As shown in the chart below, European BBB rated CLOs currently have a premium of over 240 basis points over comparable BBB corporate credit.

In fact, in our opinion, CLOs have not seemed so undervalued on a relative basis for a long time. Even though CLO spreads do not tighten significantly, the asset class appears to be an attractive carry trade.

These high levels of return can also become more pronounced as investors move down into the CLO capital structure. Currently, a European BB rated CLO tranche typically offers around 600 basis points of spread above the risk-free rate, compared to around 272 basis points for a similarly rated high yield bond index.

Finally – but perhaps most importantly – CLOs can offer much greater flexibility than regular corporate bonds, especially when income is scarce and investors are looking to increase the return on the portfolio. In high yield bonds, an investor looking for a larger spread would normally buy lower rated bonds, which could mean taking exposure to a new company where the investor may not like the story of. credit. In contrast, all the bond tranches of a CLO are backed by the same loan pool, with the same performance data and the same CLO manager. If you like BBB bonds from a CLO, our experience tells us that you will probably find it more comfortable to buy the more junior B ratings than to make the same move down the high yield credit spectrum.

Overall, as traditional bond markets appear increasingly overvalued after a relentless rally and inflation appears to be a real threat, we think the case for European CLOs is particularly compelling at this point in the cycle. .

Elena Rinaldi is portfolio manager of TwentyFour Asset Management

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