Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

When people hear acronyms like CDO or CLO, they immediately think of the financial crisis that brought down Lehman Brothers and Bear Stearns.

And perhaps it's because of that impulse to recoil that firms such as BlackRock see opportunity in the securities. Even now, eight years after that epic credit seizure, collateralized loan obligations, or CLOs, are still treated with more skepticism than similarly rated high-yield bonds or loans. As a result, they offer higher yields.

"I think the CLO market is great value," Rick Rieder, BlackRock's chief investment officer in fixed income, said in a Bloomberg Television interview this week. "CLOs are much cheaper than the underlying loan market."

For example, CLO notes with BB ratings offer investors yields of 7.75 percentage points above a benchmark rate, while similarly rated loans offer only 3.68 percentage points more, according to data compiled by Wells Fargo Securities. 

More Yield
Investors are earning higher yields owning CLOs than loans with similar ratings
Source: Wells Fargo Securities

Investing in CLO debt is sort of like collecting water from a waterfall, with the water -- in this case interest and principal payments -- coming from a pool of corporate loans. Investors who buy more senior CLO debt have the right to collect money before other more junior noteholders. Equity purchasers get to collect whatever's left over after everyone else is paid. The performance of CLOs tends to track that of the underlying loans but is subject to some unique variables.  

Swinging CLOs
CLOs have had more volatile returns this year relative to leveraged loans
Source: Palmer Square CLO Debt index, S&P Leveraged Loan 100 index

CLOs are often lumped together with collateralized debt obligations, or CDOs, because they're similar in structure. But the CDOs that were demonized in the wake of the financial crisis were backed by home mortgages and have all but disappeared. CLOs, on the other hand, have survived and thrived amid eight years of central bank stimulus. CLO buyers have taken comfort in the fact that the securities made it through the financial crisis in decent shape, without the rampant fraud that tainted the home-loan industry.

BlackRock isn't alone, of course in gravitating toward these securities in recent weeks. Japanese investors, who liquidated big holdings of this debt after the 2008 credit seizure, have been returning. Insurance companies are flooding into the more senior notes, causing yields on the securities to contract to one-year lows and spurring a wave of new CLO issuance.

The most obvious reason for the renewed interest is that investors are generally racing back to U.S. credit as the Bank of England starts buying corporate debt and the Federal Reserve signals it's in no rush to raise interest rates. Speculative-grade loans have benefited drastically, posting their best return since 2009.

Big Returns
U.S. leveraged loans are posting their biggest gains for a similar period since 2009
Source: The S&P/LSTA U.S. Leveraged Loan 100 Index

There's another, more esoteric reason. Loan investors and owners of more senior CLO notes stand to earn even more income in the next few months as Libor surges. Loans typically have floating rates and are pegged to Libor, or London Interbank Offered Rates. These benchmarks have risen to the highest levels since 2009. While analysts debate whether these rates will remain elevated, the move is already providing more meaningful income to investors.

It's easy to see why investors would find CLOs attractive in the coming months. The first impulse may be to shake one's head and say, "Haven't we seen this movie before?" Corporate credit defaults have ticked up, and lower-ranked CLOs offer leveraged exposure to that risk. Leverage plus credit risk equals scary, right?  

But it's harder to remain jaundiced when investors are paying to own debt of Germany and Japan. The list of alternatives has grown particularly slim. At least CLOs provide the promise of some regular income. So barring a significant disruptive event, these loan securitizations should continue to do well in the near future, and it's hard to criticize the investors who gravitate toward them.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net