Chinese Investors Eye Leverage to Juice U.S. CLO ReturnsBy
Investors may consider using repo financing to boost returns
Levered returns for BB-rated CLO slice may approach 20 percent
The last time Asian investors borrowed money to invest in structured-credit products - during the run-up to the financial crisis - it didn’t work out so well.
Now, a new set of buyers from China are hoping things turn out differently. Instead of snapping up packages of risky derivatives tied to U.S. home loans, they’re buying collateralized loan obligations that bundle together corporate loans to highly leveraged companies. And while such CLOs weathered the last crisis relatively well, there’s already concern that these investors are being tempted to deploy leverage to amplify their returns.
The problem is that even the riskiest pieces of CLOs can yield less than the 8 to 10 percent targets Chinese investors have grown accustomed to in their markets, according to Collin Chan, a CLO analyst at Bank of America Corp. So CLOs, the junk-rated slices of which yield just 5.5 percentage points more than Libor, “may not be crazily attractive” to them, said Chan, whose team has trekked to China multiple times this year to pitch the products to investors there.
On a recent trip to China, potential new investors expressed interest in the idea of applying leverage for the purchase of CLOs, even at the riskier BB level, Chan said. He estimates levered returns for the BB-rated CLO slice may be almost 20 percent. Leverage is employed using the repo financing market, where short-term loans allow investors to borrow money by lending securities.
It’s the latest evidence of the search for yield that has engulfed credit markets and provided a significant boost for CLO sales this year. China and its many types of financial institutions now look like promising buyers for a product that in Asia has typically been bought by Japanese banks and Korean insurers.
“It wouldn’t be wise for the Chinese to use leverage at this stage,” said Asif Khan, head of CLO origination and distribution at MUFG. “It’s dangerous territory. Leveraging BB-rated bonds - is that a good idea? Any potential use of leverage by Chinese investors could pose potential risk in case of severe volatility.”
In the U.S., typically repo financing, or the use of repurchase agreements, is utilized to lever up CLO investments, and the borrower receives a haircut on capital requirements, depending on the rating level they’re interested in. This is the same method that was pitched to Chinese investors, BofA’s Chan says.
CLO spreads briefly blew out in early 2016 amid plunging oil prices, forcing repo unwinds from AAA down the capital structure, said Oliver Wriedt, co-CEO of CIFC Asset Management. The recovery in secondary CLO prices was quicker than expected, and the buying opportunity was excellent if you timed it right, he added. However, these losses pushed the use of leverage to the side.
Wriedt says that market dynamics have now changed, and there is once again capital available for this trade.
“Leverage is just being used again; it has crept into so many different strategies now across all the markets, not just CLOs,” Wriedt said. “At this point in the cycle, strategies that were traditionally unlevered are readily accepted with some amount of leverage. It’s a direct result of compression in expected returns, and limited partners are prepared to accept leverage to achieve desired results.”
|CLO New Issue||Funding Cost||Haircut||LIBOR Spread||Leverage||WAL||1Y ROE|
Source: BofA and LCD; ballpark repo financing costs, ROE using leverage
The Next Frontier
Chinese investors have yet to enter the CLO market en masse. However signs point to their growing participation. In some cases, investment banks and CLO managers have made as many as five trips to Asia this year, adding on special CLO-focused investor conferences in mainland China for the first time ever to raise the product’s profile. The demand to diversify into dollar assets has grown from a wide range of investors, despite Chinese-government capital controls limiting deployment of capital abroad.
While Japanese, Korean, Singaporean and Taiwanese investors have been buyers of U.S. CLOs for many years -- even pre-crisis deals, in the case of Japan and Korea -- mainland China is still a relatively nascent, untapped market.
“Mainland China is the last market for us to focus on, and we’ve been there four times already this year,” CIFC’s Wriedt said.
In contrast to other Asian investors, the Chinese are more willing to invest deeper down the capital structure, or even in the riskiest equity piece.
The Chinese investor base for CLOs may be equal to the U.S. in five years’ time if capital controls are relaxed, MUFG’s Khan said. More than $106 billion of new U.S. CLOs have priced so far this year, and the vast majority of investors are still U.S.-based. Potential Chinese investors include quasi-sovereign or insurance companies, so "even a small percentage of what they will do will lead to a large capital infusion," Khan said.
“CLOs have decent diversification compared to other ABS securities and offer better yield on top of that,” said Ziyun Wang, a founding partner of Hong Kong-based cross-asset hedge fund DeepBlue Global Investment Ltd. The fund was formed this year to focus on fixed-income, and has 10 percent of its portfolio invested in CLOs since the second quarter. A CLO is a “floating-rate note, and by investing in it you are exposed to much less duration risk,” Wang said, adding that they also offer protection from rising interest rates. Recent CLO vintages also have better structural protection compared to pre-crisis transactions, Wang said.
“Over the last 18 months, Chinese investors have shown a marked increase in interest, awareness, and desire to be educated about CLOs, and they’re a pretty sophisticated audience,” said John Popp, global head and chief investment officer of the Credit Investments Group at Credit Suisse Asset Management. The company has $46 billion in assets under management, including CLOs that have a market value of $18.3 billion.
“They’ve really learned the product quickly and engage in extensive due diligence,” Popp said. “I expect to see them as steady and growing participants in the CLO market, not as tourists.”
Korean, Chinese Investment in CLOs Expected to Deepen: Panelists
Chinese CLO Investor Base May Equal U.S. in Five Years: MUFG
U.S. CLO Outlook More Certain for 2018, $110b Forecast: BofAML
Chinese Eye Leverage to Tap U.S. CLOs in ’Go Global’ Bid: BofAML
— With assistance by Carrie Hong