Q: Ron, how did the CLO market perform in 2020 and how did your fund react to the swift market conditions last year?
The biggest winner in 2020 was obviously the US tech sector. But if we narrow our comparison to fixed income then mezzanine tranches of European Collateralized Loan Obligations (CLOs) are definitely strong contenders. Despite the volatility last year, single-B rated CLOs showed total returns of over 17% and BB rated CLOs returned over 13%, significantly better than high yield bonds from both sides of the Atlantic. If you look at Investment Grade risk, European BBB rated CLOs returned over 7%, slightly below IG bonds. The European CLO returns are even more impressive if you consider the Euro appreciation against most major currencies.
Our fund was structured last year after long discussions how we can navigate through volatile markets and take advantage of inefficiencies in the market for European CLOs. We insisted on a flexible mandate that allows the portfolio manager to overweight certain type of risks without rating constraints. We also wanted a structure that can navigate through a volatile environment without facing the risk of large early redemptions that force the portfolio manager to sell in the market good assets at a disadvantageous time.
Our flexible mandate allowed us to invest in both senior and mezzanine tranches of CLOs at times of great uncertainty. Once we saw that the market is rebounding, we replaced quickly our senior risk with more junior risk. Our investments in single-B tranches represented a great risk adjusted return where we initially positioned the risk, however the market quickly bounced back to levels where we could monetize the gains that we expected to play out over a longer period of time. We replaced this risk with BB’s in the new issue market, where deal covenants were particularly friendly for debt investors. Without planning to, we turned over the portfolio one and a half times, just because we reacted to changing market conditions. This resulted in 37.10% positive performance in 2020, while keeping our risk bucket relatively low. Today our exposure to the riskiest bucket (equity and single B) is about half of the portfolio.
Q: Simon, where do you see the CLO market in relation to other asset classes going forward?
It was always anticipated that 2021 would be a year where directionality in financial markets was driven by ‘the price of money’, and so far, this has failed to disappoint. One nuance, however is the relative insulation credit markets have experienced when compared to government bond and equity markets. The volatility has only had a peripheral impact on pricing in credit trading and whilst it is not correct to say these markets have been immune from wider moves in the US treasury market and the wide range trading in US stocks; investors will have so far felt they have not been included in those particular rollercoasters.
Take February as an example; in a month where the peak to trough moves in tech stocks saw it almost revert to a bear market and the 10-year US treasuries headed for 1.5%, we actually saw the S&P European Leveraged Loan Index (ELLI) tighten around 5-10bps on the month, reflecting strong demand for loans. The consistency in the ELLI year to date stands in stark contrast to the broad and volatile range trading in the S&P/Nasdaq and the VIX.
From an investor standpoint therefore, the question is what to make of this dichotomy. Do we see that credit really is less risky or shall we say, not part of the speculative bubble that has emerged in US tech stocks and rates or is it only a matter of time before contagion effects our markets too? The reality will only be known with the benefit of hindsight; but we can point to various data points that suggest that for the CLO market on which we focus, there is a case for outperformance in the current market environment that we expect to persist in 2021.
Q: Ron, where do you see leveraged loans fundamentals and how resilient is your fund to a higher default rates in regime?
The collateral in CLOs has become riskier, in line with all asset classes. Although companies raised more cash in absolute terms last year and despite the drop in real rates since COVID, interest coverage levels have come under pressure. Another point of concern is the increase in leverage among high yield issuers; there are more issuers with DEBT/EBITDA multiples at 6 or greater and this is a direct result of the access to the increased money supply, even for issuers under financial stress.
But not everything is so gloomy. The sharp increases in loan prices have allowed collateral managers to clean up their portfolios and in the vast majority of cases, without taking meaningful losses in their portfolios. We see a decrease in assets that are rated CCC or below as well as a sharp decrease in low priced assets. This results in higher overcollateralization ratios for the debt investors in CLOs.
When we are considering an investment a large part of our decision making is influenced by the resilience of the specific investment to losses in the collateral. We not only look at the current portfolio but also try to optimize for the worst cases scenario resulting in the first Euro of loss on the investment. With our current portfolio it takes ~14% of cumulative portfolio losses before we show negative returns in the long run – this is equivalent to 28% of the collateral defaulting and recovering at 50% (long term annual default rates in European leveraged loans average 2.6% and recovery rates average 67%). I can tell you that as investors in the fund ourselves, we still go to sleep at night with comfort.