John Kerschner, head of U.S. securitized products at Janus Henderson, points out that collateralized loan obligations (CLOs) differ in dramatic ways from collateralized debt obligations (CDOs), which many blame for igniting the Great Recession of 2007-09 – despite having related structures and a certain reliance on quantitative risk models. Join us for this insightful discussion, as Kerschner highlights how the math, the models, and the makeup are different for CLOs than they were for CDOs – and why investors shouldn’t view them as a catastrophic threat to the global financial markets.
Note: Any performance figures mentioned in this podcast are as of the date of recording (August 11, 2022). Also, all references to CDOs in this podcast refer to collateralized debt obligations.
Summary – IBKR Podcasts Ep. 33
The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.
Hello, and welcome to IBKR Podcasts. I’m Steven Levine, senior market analyst at Interactive Brokers, and your host for today’s program. We’ll be speaking with John Kerschner, head of U.S. securitized products at Janus Henderson, about his insights into the collateralized loan obligation, or CLO, market.
Welcome John, thanks very much for taking the time to do this.
Thank you very much for having me. Pleasure to be here.
It’s a terrific topic. Earlier this year, there have been some reports that essentially said increased inflation, which is what we seem to be experiencing, rising rates – also, what we’re experiencing – were beneficial to stoking appetite for CLOs. And there have been more novel strategies, it seems, that have been emerging on the back of the passage of the $1.2 trillion infrastructure bill – I believe that passed this mid-November 2021. These concerned real estate and project finance, so these are brand new types of CLOs.
However, I understand that there are also some analysts that have recently lowered their expectations for CLO issuance for this year … for 2022. And this has been amid wider ‘AAA’ spreads and declining leveraged loan offerings from the prior year.
And I would just love to know what’s happening in this space. It’s been years since I’ve really looked at it, but I suppose the first question that would be helpful for those not entirely familiar with what CLOs are – or what any of this language really means, is: What are CLOs? What exactly are these products? They sound like CDOs [collateralized debt obligations], right? I remember those, but what are CLOs?
Yeah, these are completely different from CDOs, and we can talk about the difference as we go on, but CLOs, as you define them, collateralized loan obligations – they’re a securitization just like any other securitization out there. For example, very common securitizations are made out of auto loans or student loans or credit card loans. And, so, what a securitization is … is simply taking a pool of loans and putting them together, and then dividing up the cash flows into different layers of risk. So, something that got ‘AAA’ rated would be obviously the lowest amount of risk at the top of the capital stack, as we like to say, and it goes all the way down: ‘AA’, single-‘A’, triple-‘B’, and then below investment-grade, and even in ‘equity’ or ‘residual’ tranche. So, yeah, they can be confusing to investors out there. But what you should really just know is instead of investing in the individual loans, you can invest in a very diversified pool of these loans. And then the best thing for investors: you can choose the amount of risk that you want to take – either very little risk in a ‘AAA’ tranche or much more risk if you went down the capital stack.
And these are corporate loans? These are pools of corporate loans, yes?
That’s correct, yeah, that’s correct. So, like I said, usually if you think about auto loans or student loans or credit card loans – those are obviously consumer loans. The big difference with CLOs is you’re taking a pool of leveraged loans or bank loans, which are two names for the same thing, but it’s basically corporate loans, that’s correct.
And just to clarify, because I know that there was a huge question mark in terms of how the different tranches of, say, a CDO was rated. You had a ‘AAA’ rating, but that didn’t necessarily mean that that tranche represented the highest investment-grade type of credit that you would be investing in. The underlying collateral – these risky loans – are, at base, rated at least double-‘B’ plus [‘BB+’]. Is that right?
Yeah, that’s correct. And I just want to be very clear – the real difference with CDOs and CLOs:
CDOs were made-up of subprime mortgages, very slim tranches, usually triple-’B’ rated. Now, the problem with subprime mortgages is that the rating agency models were calibrated to a housing market that never went negative, and the reason for that was because it had never happened since the [Great] Depression. So, the rating agency models used data from, obviously, past cycles, and because the housing market, as a whole in the U.S., had never gone negative during a year, their models just didn’t take that into consideration, or made it as a very, kind of outsized case. So, when that actually did happen in the Global Financial Crisis [GFC] of 2008-2009, these very thin, very slim tranches of subprime mortgage risk basically went to zero. So, anything that was created from them, namely these ‘AAA’ CDOs. If they didn’t go to zero, they went very low in dollar price, and a lot of them defaulted over that time.
The nice thing about CLOs is that leveraged loans have been around since the 1980s. The default models for corporate credit go back over 100 years. And so, the models have a lot more data and a lot better calibration, and so things like the GFC not only did leveraged loans perform decently – obviously, there were defaults ’cause it was a very stressful time in the market – but even CLOs performed pretty much as expected.
And so that’s the real difference between CLOs and CDOs.
I think it’s fascinating to look at products that seem so similar in terms of their makeup, or constitution, in a sense, and see that CLOs were more resilient in their performance over the Great Financial Crisis, or the Great Recession. We’ll come back to that because I think that it’s really worth looking at CLOs in terms of the risks that they pose, and the benefits that they pose. And so, in light of that – who invests in these? Who are the investors behind it, and why would they invest in CLOs?
Yeah, it’s a great question. Pretty much any institutional investor that invests in fixed-income will also invest in CLOs.
So, at the top of the capital stack – the ‘AAA’ tranche – you’re seeing U.S. banks, about 30%; Japanese banks are huge buyers, they own about 18% of that market; and money managers own about one-third of it; and insurance companies, about 19%. And the total triple-‘A’ market is about six-to-seven hundred billion [US$600-700 billion]. So, it’s literally hundreds of billions that these different investors are buying.
In the middle of the capital stack – so, that would be ‘AA’, single-‘A’, and triple-‘B’ – it’s mostly money managers, and insurance companies, about 50-50 there. And then when you go down to the below investment-grade, or ‘equity’ tranches, it’s basically about 90% hedge funds, and maybe 10% of money managers.
And to answer your question as to why they buy them: fixed-income investments, the vast majority of them … about 95% … actually do have fixed coupon income … that means you buy a bond, you get your coupon income either semi-annually or monthly, and then at maturity you get your principal back. And that fixed coupon income never changes. That’s why when rates go up, bond prices go down and vice versa.
Floating-rate securities, which is a very … much smaller part of the fixed income markets, the coupon income actually changes, as the Fed raises rates up or down. So, right now, a lot of investors are very attracted to floating-rate instruments, mostly CLOs and leveraged loans, and a few other niche markets that are floating-rate, but that’s the vast majority of floating-rate debt in the U.S. And they want to buy those because, obviously, the Fed continues to raise interest rates. They probably will continue to raise interest rates more this year and maybe even to 2023. And that means as they do that, your coupon income continues to reset up. So, instead of being a headwind, as the Fed raises interest rates, it’s actually a tailwind, and that’s obviously very attractive to investors.
So, this is basically why I’m reading that rising inflation and higher rates are spurring this appetite. That makes a lot of sense to me now. But now I’m also seeing that – it looks like maybe in June, and maybe the situation has changed – that there perhaps had been fewer deals made in the leveraged loan space. It looks like spreads have widened on the back of this for the ‘AAA’ tranche. I’m not sure if that’s still the case, or whether sentiment in the primary market for leveraged loans has changed?
Yeah, actually, issuance in the leveraged loan market is down dramatically this year – down about 67% year-to-date. And that’s mostly from the dislocation we’ve seen this year – coming from Ukraine, and then continuing on, as just the market became more nervous about inflation in the Fed interest rate hikes. Interestingly enough, CLO issuance is only down about 10% so far this year, as many managers have continued to issue just because the demand has remained relatively high. Now CLOs, particularly the ’AAA’ tranche, has not been immune to widening as general fixed-income spreads have widened. That should almost go without saying. That being said, the demand continues for ‘AAA’ CLO tranches, principally for the reasons that we’ve described. They’ve very high credit quality. The liquidity is incredibly strong. And investors want that higher coupon income, as the Fed raises interest rates.
One interesting thing that I don’t think a lot of people would know about is that the two largest months for trading in the ‘AAA’ CLO space were: number one – March of 2020; and number two – March of 2022. So, incredibly dislocated, very difficult markets – a lot of other fixed-income markets either completely shut down, or for all intents and purposes, shut down. At the same time, ‘AAA’ CLOs actually increased their trading amount in liquidity, and we look at that as a very positive point for investing in ‘AAA’s. Because if you want to trade them, either buy them or sell them, you are able to do so even in very difficult markets.
It was interesting during that time, especially during the lockdowns. And certain industries, say, for example, the hotel industry – you had companies like Marriott getting essentially no occupancy, or zero occupancy rate, globally, it seemed. And yet they were able to come to market during that time – this is an investment-grade company – with a bond that got fairly…. It was overbooked, if you’ll forgive the pun, but it did really well. And I thought that that was very interesting that corporate bond investors were keen to still grab for yield and grab debt regardless of what the fundamental backdrop looked like. There was support for the corporate bond market, it seemed, by the Fed at the time, and I believe that they were, I think, for the first time actually entering the market to buy fixed-income instruments to keep that market liquid. So, I wonder if that has anything to do with the riskier loans, or whether they enjoyed the same kinds of benefits of a more liquid corporate bond market to support the CLO issuance.
Those are all great points, Steven. And what was so unique about COVID was, obviously, just the global economy shutting down. I think the Fed, to their credit, understood very quickly that not only did they have to come in quickly with support, but very large support to the financial markets. They kind of made that mistake in the GFC that they didn’t come in quickly enough, nor large enough, and so it took longer for the financial markets to recover. If you remember, it was actually mid-2007 when we started to see the cracks, and the markets didn’t really bottom ‘til March of 2009.
In this case, very different – the Fed came in, like I said, with support. They did start buying investment- grade corporate credit. They even – the Fed – said they may buy some high-yield corporate credit ETFs [exchange-traded funds]. They had the capability to do that. And, so, basically what investors were doing is saying, ‘Look we know this pandemic is not going to last forever. Can a firm like Marriott last for the year? Or maybe two years it’s going to take in order to come out the other side?’’ And, so, investors actually felt confident that with the Fed backing these markets that they could buy their debt of very solid companies like Marriott, and that Marriott would come out the other side. And you know, quite frankly, Marriott was able to do a deal1, it was oversubscribed, but it was at very wide spreads. Instead of maybe the low hundreds [a spread in the low 100s measured as basis points (bps) above the yield of U.S. Treasuries of similar maturities], it was probably three— or four hundred [U.S. Treasuries +300 bps or +400 bps], so that’s really what was going on right there. And credit to the Fed for kind of understanding what was going on and supporting the markets.
It was certainly a very different landscape, a very different time. Interesting to still see these deals getting done, even at the worst of times, it seems. But if we turn our attention, though, to the products themselves – the CLOs versus CDOs. And I know you gave us a great case in terms of the model calibrations with the ratings agencies, and otherwise, to come up with ‘AAA’, triple-‘B’ Investment-grade types of ratings for the tranches – that are the debt tranches – maybe not necessarily for the equity tranche, the lowest level tranche that experiences the brunt, I suppose, of losses when companies, or loans, or the underlying collateral, starts to default. So, I understand, basically, if you’re a holder of these, you are going to experience losses on them only if you’re holding, say, the mezz tranche, which would be the middle tranche, or the ‘AAA’ tranche – you’re going to experience losses if the lower tranches become depleted or defaulted up, right? So, the equity tranche experiences all the possible defaults it can before it goes to zero, and then if there’s more losses, it then starts to creep up the ladder … the structured ladder. This is what I understand.
So, let’s talk a little bit about how the loss models, I suppose, if you will, or the performance models, or the credit pricing models, work. I know that might be a big thing to really discuss here, given the scope of the conversation, but at a time when a lot of the CDOs, say back in 2008, were being calculated for losses, there wasn’t a mark-to-market, it seemed. It seemed like there was a mark-to-model. So, there was some kind of difficulty, or challenge, to actually find the prices on them during that time, depending on how the model was structured. It’s still kind of a mystery to me, a bit, even having studied a bit of what these credit pricing models were. But is the way that, say, losses are calculated … the probabilities of default, and this kind of quantitative analysis … is it the same for CLOs when you want to assess your risk on them? The same as you would with a CDO? Have the models changed?
The models have changed, absolutely. I mean, any rating agency or money manager – anybody that’s trying to price the risk – continuously updates their model, as we go through different cycles … different business cycles, different dislocations like the GFC or COVID. What’s key to remember, and I think this is a massive differentiation between CLOs and CDOs is CLOs are backed by loans, which yes, loans will occasionally default – on average, about 3% of loans default a year. Actually, currently, only about 1% are defaulting, and we think that’ll go up to two, maybe 2 1/2 next year, but it’s still a very conducive environment for credit. And loan defaults are actually quite low, but they do happen. But the nice thing about loans is most of them are collateralized by some kind of collateral, and so when a loan defaults, you don’t get zero money back, right. Traditionally, your recovery on loans, because of the collateral that backs them is $0.60 to $0.70 on the dollar. Now, that went down during COVID to more like $0.50 or even $0.40 on the dollar. But somewhere in that range between, let’s just call it $0.40 and $0.60 is what you get back. So, it’s not a complete loss for the investor, and that’s why the CLO holder is … particularly [up] the capital stack at the ‘AAA’ … are so well protected, because you can basically default 70 or 80% of the loans, but assuming a $0.50 or $0.60 recovery value on those, all that recovery value would go to pay the ‘AAA’.
Now, again, in CDOs, you were building ‘AAA’ bonds with triple-‘B’ subprime loans, and those basically had zero recovery value, because it was such a small tranche in the subprime mortgages that were issued, and so that’s why the ‘AAA’s CDOs had such a difficult time – so, many defaulted. And while ‘AAA’ CLOS – we’ve never had a default. Repeat that – the number of defaults of ‘AAA’ CLOs going back 30 years is actually zero, and think of all the stress times we’ve had over the last 30 years.
That will tell you…. No model is perfect, right? Calibration is never perfect. But that basically tells you that the models that the rating agencies are using, and the risk pricing that money managers and banks are doing, is actually working as expected. And, so, investors should take some comfort in that.
So, if you hold a piece of a CLO – let’s say you hold the ‘AAA’ tranche of a CLO, or a piece of that – let’s say some fantastic situation occurs, and you experience a default. If I hold the loan itself outright, if I went and I invested via a prospectus on a loan, which probably is going to be a hard bet because these are leveraged loans and not quite, you know, high yield corporate bonds, but I would have recourse if I was a holder of a corporate bond, right?
But if I’m a holder of CLO, I still have recourse? I suppose there’s not necessarily a manager like an issuing entity that I could go to – like AMC theater, for example….
…and go to AMC and say, ‘Hey, you know, I’m a bondholder’, so I can collect in bankruptcy or something – if that happened to them. But I’m holding a CLO. So, how does that work?
Yeah, so look, no individual investor is going to ever go to bankruptcy court and try to recover assets if they’re invested in a… let’s just say they’re investing in a leveraged loan ETF, right? Nor would they want to do that if they’re invested in a CLO ETF. So, what happens is if there is a default…. Look, there’s a set process. Bankruptcy court is very well defined in the United States. We have a rule of law here. And, so, the investors, like Janus Henderson, would be going to court on behalf of the individual investors that bought our fund, or bought our ETF. And, so, it does not behoove individual investors to actually invest in individual leveraged loans because of that very reason. It’s just it’s too much.
It’s too much bother. And really, Steven, it just comes down to the fact that that’s why investors need to hire people like Janus Henderson or other money managers with active management. Because we are spending hours and hours every day pricing this risk, investing in leveraged loans and / or CLOs that we think have good underlying fundamentals. And that, like I said, inevitably, some firms will go bankrupt, but that’s why you have a diversified portfolio to offset that, and that’s why you get paid more risk to go into those securities. Does that help clarify that?
It completely does. I hate it when I buy something, and I can’t call somebody if have questions about it, for example, where it seems like I just hit some automated machine that guides me through, you know, 10,000 different options.
I never get to talk to somebody, and all the while I just want to make it work. So, this makes a lot of sense to me. This is great.
I just wanted to kind of go through the current situation that we’re experiencing, ’cause there seems to be, obviously, a lot of uncertainty, a lot of volatility. And I know in 2020 we experienced a great deal of retailers default. I think some energy companies as well – several sectors, I think most sectors … business sectors of the economy … experienced default rates that were above their long-term averages. I think almost 200 speculative-grade companies, according, I believe, to S&P, who experienced defaults in 2020. And, so, now we’ve had a couple of quarters of negative growth. We’ve got inflation still fairly high. We’ve got a lot of geopolitical tensions. We’ve got, yes, the rising rates may help the technicals, I suppose, of the attraction for bondholders to want to come in and purchase CLOs … But more on the fundamental side, and I know you talked about default rates – maybe 2% next year…. Do you think that we could experience something as cataclysmic as the Great Recession if there were multiple defaults happening at one time? And I think that there was an article published by the Atlantic – I believe it was a UC Berkeley law professor – Frank Partnoy – and he wrote about ‘The Looming Bank Collapse,’ and he really put a spotlight on CLOs. And this was, I think, in the midst of 2020 that this came out. And he’s really saying, I believe, that nobody could have accounted for simultaneous defaults, or that ‘correlation default’ that happened with CDOs – and I think you mentioned it earlier about the models…. But could we experience something fundamentally similar within the next, say, few years?
I read that article. I’ve read it several times. And it came out during a very scary time in the markets – obviously, because COVID was in full swing. We didn’t have the vaccines yet or anything, but he makes some good points, but his conclusions are very far off. And, look, this is a gentleman – obviously very learned – but he hasn’t worked in the finance industry for, you know, going on 30 years now. So, I don’t know anybody that would…. any kind of industry… where you take someone that’s been out of it for 30 years and look to them as being an expert.
At one point, one good point he does make is that many models that the rating agencies use are over-relying on diversification. And what I mean by that is they look at, like you said, different industries, different issuers of leveraged loans, and they say, ‘Well, look, you know, different industries cycle at different times. Healthcare might be doing well at one point, tech not so well, vice versa.’ So that when you get a circumstance like the Global Financial Crisis, when everything does badly, their models start to break down a bit for sure. The problem is – he [Partnoy] takes it to the extreme in saying that – look, because 13,000, that’s the number he used, ‘AAA’ CDOs defaulted. And that he used these terms that CLOs are both remarkably alike and similarly risky, that in another dislocation that was similar to the GFC that ‘AAA’ CLOs could start to default.
Well, my pushback would be, yes, you’re correct: 13,000 ‘AAA’ CDOs did default during that time for the reasons I mentioned. But zero, and again, I repeat, the number was zero, ‘AAA’ CLOs defaulted. So, how can you call those similarly risky? It just makes no sense. And, so, he comes up with this scenario where you start to have cracks in the system and that leverage loan issuers start to default, and as that happens, it becomes this negative feedback loop, where more and more defaults … and that could eventually feed its way up the capital structure and that ‘AAA’ CLOs would default. Well, first of all, the Fed is not going to let that happen. Now, you should say, ‘Well, the market shouldn’t rely on the Fed.’ I 100% agree with that. But, if … and just for context, during the GFC – about the worst year for leveraged loans – defaults was about 7% or 8%, and the worst month was about 14%. And to default a ‘AAA’ CLO, you need about 80% of the leverage loans to default. So, you’re talking four, or five … six times worse than the GFC, and for your younger listeners, that was an incredibly scary time. There were people in our industry that were going in the bank and taking out thousands of dollars worth of cash ’cause they were worried their ATMs were going to shut down and their credit cards weren’t going to work. People really thought the global financial system could implode. No one’s worried about that now.
So, my problem with that article was he was just taking it to an extreme, and can I come up with scenarios, you know, global nuclear war … asteroid hits the earth, sure, but, you know, that’s not finance, right?
We’ll have a lot of other things to worry about if those things happen.
Exactly. And in that scenario, stocks are going to be down 90%. High yield bonds are going to be trading at $0.20 on a dollar. The problem is – unless you’re buying guns and ammo and gold and can’t take any risk whatsoever, then yeah, maybe you listen to that kind of scenario. But it is proven over the 30 years that have been around, ‘AAA’ CLOs are one of the safest sectors of the market out there, and we believe that will continue to be the case. I mean, we’re constantly doing our due diligence, but the numbers prove it.
Yes, you would have to consider very, very worst-case scenarios. An entire sector goes out of business, where all the speculative grade credits implode at the same time, and, you know, you can come up, yes, with these kinds of ‘what if’ scenarios: if this were to happen, would it be cataclysmic? The likelihood of all, say, energy companies going out of business because there’s a forced transition towards renewable energies, and all of a sudden, there’s a blanket ban on all fossil fuels…. And I suppose something like that could happen…. But the chances of it happening, in terms of its disruption to the marketplace and perhaps killing a great deal of CLO holders, at the same time, I think that that would probably be taken into consideration [by the Fed], but I’m not sure.
Yeah, and let me just make one point on that so investors realize this. The reason why you want a securitization is ’cause there are all these limits as far as how concentrated portfolios can be. So, this gets back to diversification. And, again, to your point, you don’t want to solely rely on diversification, but to take your example … most CLOs only have a 2% or 3% exposure to energy, so, literally, every energy leveraged loan could default, and you’re still only looking at losses of a few percent. That would hurt the equity tranche, and that’s it. Even the single-‘B’ tranche, or a double-‘B’ tranche, wouldn’t be affected at that point. Now, if that happened, obviously, spreads would widen … maybe it has secondary effects and things like that, but the diversification, as far as industry and issuer, is in the securitization to protect investors from that very remote, but, you know, maybe potential eventuality. I would say it wouldn’t happen, but you never know, and that’s why they’re structured the way they are to protect investors from something like that.
Well, I’m glad I brought it up just to get that response. So, thank you very much.
John, this has been really, really terrific, and I know there’s a lot of other things going on in the CLO market, and I hope you’ll come back and join us, again – maybe discuss those as well. I know the NAIC [National Association of Insurance Commissioners], I think, has a proposal out there for increasing risk-based capital on the tranches. Anyway, it would be great to talk about that – if you’d come back. I think that’d be great.
It’d be my pleasure, Steven. I really enjoyed the conversation.
Yeah, same here, same here. Thank you so much!
And you can read more market commentary, analysis, and insights from Janus Henderson at IBKR Traders’ Insight at tradersinsight.news. They also have lots of fascinating articles there, with some recent topics that delve into market volatility, biopharma research, the semiconductor sector, and more.
And until next time, I’m Steven Levine with Interactive Brokers.
- April 14, 2020: Marriott International (NASDAQ: MAR) sold US$1.6 billion of triple-‘B’ rated (‘Baa3/BBB-‘) senior notes at a price to yield 5.75%, while the yield on the five-year U.S. Treasury note was bid at around 0.424%. On the day the transaction priced, Ron Quigley, head of fixed income syndicate at Mischler Financial, wrote that the deal was done “on the heels of receiving a revision for downgrade/watch negative tag from the ratings agencies.” Quigley said the order book was $20 billion, making for a 20-times bid-to-cover rate, “virtually unheard of in the new issue space”. The deal started from [initial price talk] IPTs in the 7.25% “area” to 6.00% “area” guidance (+/-12.5) before upsizing to $1.6 billion at an even tighter 5.75% launch. Quigley added, “That’s a new all-time new issue compression record of 150 bps in spread tightening from the announcement to launch. Simply stupendous! This is what’s going on in the IG Corporate new issue market folks!”
S&P Global Ratings, which assigned a ‘BBB-’ credit rating to Marriott’s senior note sale, noted it expected the company to use the proceeds from the issuance to bolster its cash balances and its liquidity position “given the significant negative impact of the coronavirus pandemic.”
S&P cut Marriott’s credit rating in mid-March 2020 by one notch to ‘BBB-’ from ‘BBB’ and placed the issuer on CreditWatch with negative implications.
See more details about Marriott’s debt issuance in its SEC filing here.
For more about CLOs and their general structure:
Leveraged Lending and CLOs:
- S&P Global: Leveraged Loan Primer
- Reuters: U.S. banks take hit on leveraged loan as deals slump, rates rise (7/18/2022)
- Forbes: The U.S. Leveraged Finance Market Is At A Record $3 Trillion (8/10/2021)
- U.S. House of Representatives’ Committee on Financial Services – From the Subcommittee on Consumer Protection and Financial Institutions: Emerging Threats to Stability: Considering the Systemic Risk of Leveraged Lending (6/4/2019).
For more information about corporate bonds:
IBKR Traders’ Academy
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