Where’s The Credit Opportunity In 2013?

Tags

CDOs, CLOs, Collateralized Loan Obligations, Colony Financial, Fed, income/dividend bubble, junk bonds, leveraged loans, mortgage hedge funds

Owning Colony Financial (CLNY:US) was v rewarding. I bought it as a cheap distressed assets play, but I suspect my gains actually came from income investors, who are now rushing into the stock. That got me thinking… And it hammered home a couple of lessons: a) Never under-estimate the desperation of income investors, and (more seriously) b) Don’t fight the Fed! Now, that may sound like a contrarian challenge to some – sure, sometimes it can prove v profitable to fight a rising tide.

Except surfing the big waves is simply far more rewarding most of the time. Do you really want to be the investor who faces down the Fed’s steamrolling printing press? Especially with a ravenous horde of zombie income investors chasing after it?!

But it’s becoming increasingly difficult to exploit those lessons. Look around, most yields are too low, most prices too high… Look at property REITs, mortgage REITs, MLPs, closed-end funds (esp. Pimco!), and other assorted dividend story stocks. Most are now sporting fairly nauseating valuations & leverage – while the dregs are simply Ponzi schemes, relentlessly issuing stock & debt to fund excessive dividends. But what’s the alternative – Treasuries?! Oh please, just stab me with a rusty fork.

Junk bonds? Their call provisions now promise near zero upside, but they still offer plenty of price & default risk if individual companies and/or the economy go horribly wrong. In fact, most bond/income investments now offer that v same proposition – financial repression‘s virtually eliminated any rate-related upside, while rising rates would cause Christ knows how much carnage… Oh, come back Bernie, all is forgiven.

So, is there any value left to buy? Which still offers decent upside potential, may have some defensive merit, and might even suck in the income rabble eventually? Or even the hedge funds? 2012 was definitely the year for mortgage exotica, so what’s it gonna be in 2013? Here’s my bet…let me whisper it, I don’t want to scare the horses:

Collateralized Loan Obligations (CLOs)

Ouch, feeling some shrinkage there?! OK, steady on – actually, it may not be as horrible as you think..!

CLOs are basically a sub-set of Collateralized Debt Obligations (CDOs) – yes, that evil toxic waste which almost destroyed the world in 2007-08! [Structured Investment Vehicles (SIVs), CDO-Squared & CDO-Cubed are other bastard variations]. Yeah, I know, scary stuff – you might want to close your eyes reading this. But let’s just take it a step at a time:

– Leveraged loans are loans made to highly leveraged companies, co’s acquired by private equity firms (LBOs), or (occasionally) middle market co’s. Commercial & investment banks arrange the loans & syndicate them out to a wide variety of financial & investment institutions.

– Leveraged loans are obviously non-investment grade, but are secured on the borrower’s assets (thereby ensuring seniority in the capital structure, and higher average recovery rates), covenants are strict, and they’re repayable at any time. As you’d expect, leveraged loan yields trade lower than junk bonds.

– They’re generally floating rate (with a minimum floor), and priced at a significant spread to LIBOR (dependent on credit quality). This offers a somewhat unique opportunity in the credit space – they’re pretty price insensitive to rising (and even falling) interest rates. [btw Another common definition of a leveraged loan is any loan priced at LIBOR + 150 bps, or higher].

– Based on historically low rates, banks who are still intent on de-risking and/or reducing their balance sheets, and insatiable fixed income investor appetite, there’s been huge opportunity to issue & re-finance – the leveraged loan market is booming:

– CLOs are securitization vehicles that invest in leveraged loans. Their liabilities are tranched (ranging from AAA down to BBB notes, a mezzanine tranche, and finally a residual equity tranche), with a waterfall structure for principal & interest payments. This simply means AAA note claims are satisfied first, before any cash flows down to the next-rated tranche, and so on. The residual equity tranche receives all remaining cashflows, once all other claims have been satisfied.

– The inverse is also true – that is, all loan default losses are first absorbed by the residual equity tranche, then the mezzanine, the BBB notes, and ultimately by the AAA notes (ideally in v rare circumstances).

– Most CLOs offer additional loss protections: i) Credit enhancement – credit insurance/guarantees, ii) Excess spread & reserves – a positive interest spread’s earned, which may be used to build loss reserves, iii) Overcollateralization (O/C) – the CLO sponsor adds additional collateral, say an extra $5 mio for every $100 mio of assets, and iv) Early amortization – an increased level of defaults, and/or certain other events, may trigger an accelerated repayment of principal (AAA notes have priority, of course).

– CLO managers have to respect certain parameters throughout the life of the CLO. These include the weighted-average rating factor (WARF), the weighted-average spread (WAS) (ensures assets are selected to earn a sufficient rate spread vs. liabilities), and the weighted-average recovery rating (WARR). Most importantly, specific overcollateralization (O/C) & interest coverage (I/C) tests are set for the CLO portfolio. If tests are breached, amortization (& other remediation actions) are commonly triggered.

– The structure, diversification & additional loss mitigation inherent in CLOs should imply a spread discount to the underlying leveraged loans. In fact, they continue to trade at a significant premium – a lingering hangover from the whole 2007-08 CDO debacle.

This highlights a key misconception, and opportunity…

– At their core, CDOs invested in property assets/mortgages, and were built & invested in based on a limited data set, and models & assumptions that never envisaged a nationwide decline in property values. And so, one unprecedented collapse inevitably led to others… Of course, this was all exacerbated by the escalation & wide-scale acceptance of sub-prime underwriting standards & mortgages.

– CLOs, on the other hand, were built on the back of nearly a century of corporate credit history. And this worked – yes, CLOs performed well during the financial crisis & emerged with flying colours! Yes, that may be hard to swallow – I definitely recommend you do your own ‘CLOs performed well‘ Google search.

– But now investors are increasingly waking up to this opportunity. Particularly hedge funds – with large 2012 gains realized in RMBS & CMBS, the entire CLO space may prove a v attractive opportunity for them in 2013. Couple that with the positive supply/demand factors I highlighted above for leveraged loans, and CLO volume is now exploding:

Now I look, I think these charts spell opportunity far better than anything else I’ve just written! And I’m confident we’ll see further substantial growth in CLO volume & demand this year. It’s v reasonable to expect this will (rather inevitably) lead to a significant catch-up & compression in CLO yields/IRRs.

So, we’ve reached the burning question: What’s the best CLO investment?

I’ll tackle that in my next post.

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