Shahzada Omar Saeed has an MBA in financial management and is head of the high-yield team at Swisscanto Asset Management, where he is responsible for overseeing investments of US$1 billion. He is lead manager for the Swisscanto (CH) Institutional Bond Fund—Global High Yield I and the Swisscanto (LU) Bond Invest Short Duration Global High Yield fund. Under his leadership, Swisscanto has experienced exponential growth of greater than 300%, along with achieving top-quartile ranking for its flagship institutional bond fund. Before Swisscanto, Saeed worked for Western Asset in London, where he was responsible for co-managing some €750 million of high-yield and leveraged-loan portfolios. Prior to that he held a similar position with F&C Asset Management.
The collateralized loan obligations (CLO) market was a major source of funding in the European capital markets for companies looking to raise debt. What is likely to happen to this market through 2012?
There is no doubt that demand for CLOs is diminishing. Until 2008 they made up about two-thirds of the European leveraged-loan market. However, after the crash of 2008 and the collapse of collateralized debt obligations (CDO) or structured debt in general, demand for CLOs has virtually disappeared. A CLO is a bundle, or pool, of corporate loans made by a bank or a group of banks. Like CDOs, which were backed by mortgage securities and which are now regarded as a major toxic element in the crash, a CLO is a structured investment vehicle. It is divided into tranches of increasing risk and increasing reward. The most senior tranche of a CLO pays a modest rate on the debt, and investors holding the senior tranche are paid off first on the maturity of the CLO. The investors holding the next tranche are paid a higher premium and are paid off after the senior investors, assuming that there is sufficient money remaining in the CLO. The same for the next tranche, and so on.
Investors holding the tranche with the highest premium are the last to be paid, so their money is the most at risk. However, a significant proportion of leveraged loans within the CLO would have to default and pay very little in the pound, euro, or dollar before this class of investor took serious capital losses. For this reason, the higher-risk layers of CLOs were seen as attractive by institutional investors across Europe until the 2008 crash. However, CLOs are, by their nature, structured investment vehicles, and these vehicles are to a very large extent no longer viewed as feasible options by European investors.
Another point is that CLOs are inherently leveraged vehicles. Prior to 2008 leverage multiples were very aggressive (10–15 times) and the cost of financing this leverage was very low (Libor + 20 bps). This low cost was because the bulk of the CLO tranches were rated AA and above. With diminished demand for structured debt, leverage multiples drastically reduced to three to six times and cost of financing moved significantly higher compared to the past (Libor + 300 bps). As a result, the only survival option for the remaining vehicles is if spreads for leveraged loans remain significantly wider on a sustainable basis. Hence, European CLO markets are likely to shrink by some 75% as a consequence.
The troubles of the CLO markets play very well for the high-yield corporate bond market in Europe, which is now growing as companies look to renew debt that used to be serviced by CLOs. However, the general lack of appetite for CLOs in Europe, which makes them nearly impossible to roll over as new CLOs, creates a further problem. The maturity profile of most of the CLOs that are still running has a maturity date that is around the same time as the loans themselves become due. The banks cannot sell the CLOs on since there is very little duration left, so they are going to have to find the money to pay out to the investors on the maturity of the CLO and then hope that corporate borrowers can meet their debt at maturity or the CLO investors could lose significantly. With the diminished appetite in the market, it is clear that when current CLOs reach their maturity that will effectively be the end of the CLO market in Europe for the foreseeable future.
What does the diminished appetite of the CLO market mean for investors in high-yield corporate bonds?
Inevitably, the proportion of leveraged loans to high-yield corporate bonds is increasingly switching in favor of bonds. Given that a significant maturity wall of leveraged loans is due over the next two years, in the face of this demand for credit high-yield bond investors have been able to secure better terms for themselves than has historically been possible.
To put some color on this, since the Lehman Brothers crisis in September 2008, 50% of all new debt issuance has been as secured high-yield bonds, which means that the bond is backed by assets of one sort of another, be they security against property, cash flows, or whatever. The historic position was that secured high-yield bonds were a rarity. Intuitively, bond investors securing better terms should have a lower premium, but, to the contrary, bond coupons have actually moved slightly higher. Before the move from CLO to bonds began, the coupon averaged 7.25%. Today the average coupon is 7.4–7.5%, so not only do the bonds come with securities that guarantee that a high percentage of the capital will be recovered in the event of a default, but the investor gets a good coupon rate as well. What this means is that if you make four years of coupons and you get a 70% recovery on a default in the fifth year, you have, from an economic standpoint, lost nothing on that particular bond and your portfolio of bond holdings is not damaged. The 70% return on capital in a default is the history of the index for defaults, so that is not an unreasonable assumption. For me, in an era of low returns, this makes the return from investing in high-yield corporate bonds very attractive.