An Unknown Risk in Bond Funds
Are CLOs making your bond fund a wolf in sheep’s clothing?
Investors in some fixed income funds may be taking on more risk than they know as portfolio managers add Collateralized Loan Obligations1 exposure (CLOs) to boost yields.
A CLO is a type of structured credit, where the bulk of the underlying collateral pool is comprised of non-investment grade, senior-secured bank loans. CLOs are divided into separate tranches, each of which has a different risk/return profile based on its priority of claim on the cash flows produced by the underlying loan pool. The riskiest pieces of these credit instruments can bring yields of 12%, so no wonder they have appeal.
Where can investors find them in a bond fund? Typically, they are part of the “securitized” piece of a fund portfolio, which on average for an intermediate core plus bond fund represents 39.2% of assets.2 What percentage of your fund’s securitization bucket is made up of CLOs? It can be hard to tell.
At present, about $700 billion of those corporate loans3 have been securitized into CLOs and sold in tranches to investors, including mutual funds. The Fed estimated that about 16% of outstanding CLOs were owned by mutual funds at the end of 20184 and Barclays put the mutual fund ownership range at 10 to 13% for the end of 2019.5
Sources: Citi Research, LCD, as of 1/31/2020
Does that growl sound familiar?6
Recently, there have been some cracks in the foundation of the CLO market7, despite 2019 having been the third largest year for CLO issuance. Credit rating downgrades of underlying U.S. corporate loans within CLOs considered “highly speculative” accelerated in 2019. Those rated B- or lower now take a near 20% share of the market. That share is the highest since 2009 when such downgrades shot up to 30%. At the same time, EBITDA8 growth for loan issuers in the S&P/LSTA Index9 dropped sharply, from 10% in 2018’s fourth quarter to 1.7–2.7% over the first three quarters of 2019.10
Sure, issuers credit-enhance by over-collateralizing tranches to help CLOs look good but remember how a few defaults can cause liquidity to dry up overnight.11 Also, recall that these instruments are not standardized. Advisors may not have access to the details.
Bigger and badder than ever
Covenant-lite leveraged loans comprised more than 80% of all new leveraged loans issuance during the first three quarters of 2019.12 The current crop of “cov-lites” has moved to new frontiers, such as EBITDA add-backs, weakening of asset liens, and loss of control over additional debt incurrence. In fact, the runway to default can be long and borrower-friendly for such loans, which may not be best for CLO holders.
Confronting the inner wolf
So, what should an advisor do? Ask bond fund portfolio managers what’s really in their securitized book. If it is scary, consider reducing downside risk by switching to funds that are transparent about their holdings.
Remember, fixed income’s key role in a portfolio is to help with capital preservation by adding stability, diversification, and generating income. Opportunities still exist in the credit markets but finding them requires a keen emphasis on bottom-up credit selectivity.
1Loans and bonds are both debt instruments. A securitized pool of loans becomes a form of bond.
2Source: Morningstar, December 31, 2019
3Includes $200 billion denominated in Euros
4Source: Board of Governor of the Federal Reserve System, FEDS Notes, “Who Owns U.S. CLO Securities?”, July 19, 2019
5Source: Barclays Global CLO Primer presentation January 2020
6The General Financial Crisis of 2008 was fueled by a rash of defaults of underlying sub-prime mortgages which had been securitized in mortgage-backed securities (MBS) and sold to insurance companies and banks.
7Source: S&P Global Market Intelligence, “Those $700B in US CLOs: Who holds them, what risk they pose”, June 21, 2019
8EBITDA – Earnings Before Income Tax, Depreciation and Amortization, an approximate measure of a company's operating cash flow based on data from the company's income statement.
9The S&P/LSTA (Loan Syndications and Trading Association) Leveraged Loan 100 Index (LL100) dates back to 2002 and is a daily tradable index for the U.S. market that seeks to mirror the market-weighted performance of the largest institutional leveraged loans, as determined by criteria
10LCD, an offering of S&P Global Market Intelligence
11Recall the ripple effects of defaulting junk bonds in Third Avenue’s Focused Credit fund in 2015 or of the Russian financial crisis on Long Term Capital Management in 1998.
12Source: Morningstar, “Should You Worry About CLOs in Your Funds?” Sep 24, 2019