The riskiest portions of specialized loan funds that have helped finance the biggest buyouts in history are luring investors with returns that exceed even junk bonds.
The equity slices of U.S. collateralized loan obligations, which get whatever money is left-over after more senior investors are paid, returned an average 16 percent last year, according to JPMorgan Chase & Co. data on funds raised since the end of 2008. That compares with 7.4 percent for the Bank of America Merrill Lynch U.S. High-Yield Index of bonds.
Investors say the prospect for above-average returns remains, even as the Federal Reserve starts to flag that it will raise interest rates as soon as next year. Demand for the equity slices of CLOs is helping fuel issuance, providing money for the neediest borrowers.
“We have been enjoying the extraordinary benefit” of the extra yield “for some time,” Robert Klein, a managing director at New York-based Prospect Capital Corp. (PSEC), said in a telephone call yesterday, noting the firm has about $1 billion invested in CLO equity.
CLOs are a type of collateralized debt obligation that pool high-yield, high-risk loans and slice them into securities of varying risk and return. High-yield, or junk, debt is rated below Baa3 by Moody’s Investors Service or lower than BBB- by Standard & Poor’s.
The approximately $300 billion CLO market has provided financing to back the leveraged buyouts of Dell Inc. and given credit to Hilton Worldwide Holdings Inc. to refinance existing debt. The funds helped drive record issuance of leveraged loans in 2013, with $355 billion of new deals arranged in the U.S., according to data compiled by Bloomberg.
For most investors except those in the equity piece, CLOs make interest payments at a preset amount that floats above the three-month London interbank offered rate. For example, a top-rated slice on new CLOs this month pays a coupon of about 1.5 percentage points more than Libor, which is currently 0.23 percent, according to data compiled by Bloomberg. Equity investors are paid after debt-holders get their distributions.
The returns enjoyed by equity holders have been boosted by about an extra 7.5 percentage points because most of the speculative-grade loans the CLOs own pay interest at a rate that floats above a minimum, usually about 1 percent, Vishwanath Tirupattur, global head of securitized products research at Morgan Stanley (MS) in New York, estimated in a telephone interview on April 11.
Libor floors have been “a huge benefit the last few years,” Allen Fu, head of CLO trading at RBC Capital Markets LLC in New York, said in a telephone interview yesterday.
The high returns have boosted demand for CLOs and helped prop up a junk-loan market that U.S. regulators are concerned is frothy. Last year, the Fed and the Office of the Comptroller of the Currency told banks to improve their underwriting standards.
As Libor rises to 1 percent, that difference between the interest payments the CLO receives and what it pays out to investors will shrink, making issuance challenging because investor appetite may dwindle, Ken Kroszner, a CLO analyst at Royal Bank of Scotland Group Plc in Stamford, Connecticut, said in a telephone interview this month. Returns would fall “well below” what equity buyers require in order to invest, he said.
Futures show that traders expect Libor to stay below 1 percent for more than a year-and-a-half, according to RBS data.
“If short-term interest rates go up faster than the market expects, that will take away some of the economics available to equity investors,” John Wright, managing director at Boston-based Sankaty Advisors LLC, said in a telephone interview this month.
Sankaty, the credit unit of private-equity firm Bain Capital LLC, manages about $22 billion including CLOs.
Investors poured a record $61.3 billion into leveraged loan mutual funds last year, according to Morningstar Inc. data, as they sought protection against rising rates. CLOs were the largest buyers of high-yield loans in 2013, with a 53 percent market share, according to the New York-based Loan Syndications and Trading Association.
Sales of CLOs reached $82 billion in 2013, the third-largest year on record, and have topped $32 billion in 2014, according to RBS.
“In the face of inevitable rising interest rates, we have tended to have a bias towards floating versus fixed investments,” James Hunt, chief executive officer at THL Credit Inc. (TCRD) said in a March 6 earnings call.
He said the firm has been “opportunistic in strategically” investing in “higher-yielding investments.” THL closed on four new CLO equity investments totaling $32 million last year, that are expected to yield 13.6 percent, he said, according to a transcript of the call. Hunt didn’t return calls seeking comment.
“The presence of the Libor floor boosts the all-in loan spread and that is helpful to CLO equity,” Maggie Wang, head of U.S. CLO research at JPMorgan in New York, said in a telephone interview this month.
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