June 20, 2019 - Over the past several months, there has been considerable discussion around CLOs, their alleged opacity, their investors and their long-term stabilizing (or destabilizing) effect on financial markets. Below, we recap the debate and reveal the (not so secret) facts about CLOs.
First, on the stabilizing side, Federal Reserve Vice Chairman Randall Quarles has repeatedly noted that any potential systemic risk of leveraged loans should be muted because they are held by “more stable holding structures” such as CLOs. On the other hand, as we reported in early June, a recent House Financial Services Sub-Committee Hearing on loans and systemic risk discussed the role of CLOs in detail, with some lawmakers and witnesses suggesting that CLOs are opaque and wondering who invests in them. Fortunately, we have clarifications and answers for the wonderers.
First, let’s tackle the opacity question. To do so, we would direct wonderers to several easily available sources. First, LPC’s Leveraged Loan Monthly deconstructs trends in the CLO market, looking at issuance, spreads, ratings, price distributions and more. In particular, for those asserting that CLO loan holdings are opaque, we would direct them to Slide 53 that lists the top 50 loan holdings in CLOs, Slide 55 for industry exposures and Slide 60 for price distributions of loan holdings. And, of course, individual CLO holdings are available through trustee reports and reporting services.
Next, we would direct interested parties to LCD’s CLO landing page, which includes real time issuance figures, analysis and scrolling CLO headlines. Both LPC and LCD also have databanks listing individual deals, managers, tranches and more. Creditflux, meanwhile, is devoted to CLO and credit news. In addition, rating agencies publish frequently on the CLO market. For instance, both Moody’s and S&P have released statistics showing the de minimus loss rates on CLO tranches.
And, of course, there are reams of sellside research, some of which recently drilled into who is buying and holding CLO notes. In particular, Citi’s CLO 2019 Midyear Outlook analyzed the market share of different investor types. According to Citi (and recapped by LCD), banks are the biggest single buyer of CLO AAA notes. Last year, they purchased over 50% of CLO AAAs; this year they are buying roughly 45% of CLO AAAs. The other major buyers down the capital stack are insurance companies and asset managers. Within the bank universe, both U.S. banks and Japanese banks have significant investments in CLOs. Japanese banks hold roughly $80 billion of outstanding CLO notes. However, with Japanese Risk Retention emerging earlier this year, Japanese bank buying has slowed as they assess the regulations, LCD reports. Meanwhile U.S. banks hold roughly $90 billion of U.S. CLO notes; LCD helpfully (transparently!) lists the CLO holdings of those banks.
Insurance companies also are major holders of CLO AAA and mezzanine tranches, as both Moody’s and the NAIC reported recently (albeit using different collection methodologies and thus getting somewhat different volumes). Based on book/adjusted carrying value (BACV), NAIC tracked $122 billion of U.S. insurance company investments in CLOs at the end of 2018. This was divided into Life ($94 billion), Property/Casualty ($24 billion), Heath ($3.5 billion) and Fraternal ($445 million). Using statutory carrying value, Moody’s tracked $79 billion in U.S. life insurance investments in CLOs. While the volumes are slightly different, the two sources came to similar conclusions: First, insurance company investments in CLOs have been increasing. Second, insurance companies are generally invested in highly rated tranches: 35% of investments are in AAA tranches, 14% in AA tranches, 17% in A or Baa rated tranches, 2% in Ba and below and 32% in tranches not rated by Moodys. Moreover, 79% of those “not-rated” tranches are NAIC 1, or single-A or better.
While banks and insurance companies have significant CLO investments, that does not mean they face considerable credit risk. As noted above, banks invest almost exclusively in AAA and AA notes, while insurance company mostly invest in notes rated A or better. According to Moody’s, there has never been a default in a CLO AAA or AA note and the loss rate in A rated tranches is just 0.1%. (A much better record than equivalently-rated corporate bonds, we’d gently observe.) In addition, Wells Fargo has analyzed the loan default and loss rates would be required to cause a break in principal for different CLO tranches. Assuming a 65% recovery rate – approximately the recovery rates that rating agencies assume today – it would take a 100%, 52% and 29% annual default rate to create credit losses on AAA, AA and A rated CLO notes, respectively. So, the CLO investments of banks and insurance companies appear rather safe. Further down the CLO capital stack, asset managers become the predominant investors. Thus far in 2019, they account for 40% of mezzanine holdings and 80% of equity holdings (likely because many of the 2019 CLOs are seeing managers hold the equity of their own CLOs). And this should give comfort to those CLO commentators (many of whom championed risk retention). After all, asset managers are exactly the entities expected to take credit risk in exchange for higher returns.