Why CLOs have fared better during challenging periods than other structured credit investments and why they are poised to do so in the future

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Impairment Rates: A Tool for Evaluating Structured Credit

Any losses experienced within a group of CLOs over a period of time is called an impairment rate. In other words, if 1 out of 10 CLO investments experienced a loss, then it is a 10% impairment for the group of CLOs, regardless of the loss rate amount for the single CLO. Comparing impairment rates for CLOs and other structured credit products reveals an obvious distinction – CLOs have experienced much lower historical impairment rates than other structured credit investments.

Why might this be? We believe there are two primary reasons:

1. Nature of the collateral and the motivations of the underlying borrowers
2. Large pools of loans, diversified by industry, in underlying CLOs

The CLO Collateral (Senior Secured Loans) and Underlying Borrower Incentives

Most structured credit products operate in a similar manner: they pool together a specific type of credit investment, and use the interest revenue generated from these credit investments to pay its investors. Some structured credit products pool together only mortgage loans (these are known as CMBS), while others may pool corporate or business loans (e.g., CLOs). However, in Bluerock’s view the difference in credit investment type is ultimately what makes CLOs with their underlying corporate loans potentially more attractive that products that pool together other types of loans.  A key advantage lies in the incentives and motivations of those very same underlying corporate borrowers.

Consider the recent case of CMBS defaults. Contrary to typical structuring, one of these structured CMBS products had a single mortgage that generated the interest revenue for all the CMBS investors, instead of a pool of mortgages. This creates an unnecessary structural challenge, which caused even the AAA tranche investors to experience significant losses. However, contributing to the investors’ losses was the default itself. The single mortgage loan was on an office property, and the current value of the property is far lower than the loan amount outstanding on the mortgage. Therefore, prospect for recovery was slim, options are very limited and mostly out of the control of the office property owner (as it is more dependent on the broader office real estate market). Furthermore, the office building owner who gave up the asset can seek another property to invest in, given the nationwide market for properties.

With CLOs the situation is fundamentally different. These hold a type of corporate loan called “senior secured loans,” which are secured by a company’s assets (cash, receivables, inventory, property, etc.). Consequently, a default on these loans and subsequent loss of company assets is significantly more impactful to the business.

For example, let’s say an airline issues a senior secured loan, and secures it with corporate assets. During a recession, an airline may face weaker revenues from lower traveler numbers and may be challenged in meeting its loan obligations. Although the recession is outside the airline management team’s control, they can still take numerous actions to raise capital or reduce expenditures to meet the loan obligations, such as lay off staff or reduce flights, as these cutbacks can be reversed in the future. However, management is less likely to allow the loan to default, as this would both impact the airline company’s future ability to generate revenue (as the jets themselves may be part of the secured collateral that is liquidated by creditors), and would also destroy all owner equity during the bankruptcy process, which may be a significant part of the same management team’s compensation. In this way, a structured product with a senior secured loan backed by a company’s assets where underlying management teams are incentivized for long-term success is likely to fare better than one backed by more passive assets such as the office building example above.

Diversification of Underlying Loans

Many of the non-CLO structured products have high industry concentration. CMBS are backed by commercial real estate loans, RMBS by residential real estate loans, ABS by credit card receivables among other consumer debt. Conversely, CLOs can only gain market adoption if they are backed by a wide range of companies and industries. For example, when real estate may be lagging, technology may be strong and when health care might be struggling, media, leisure, or other industries might be performing strongly. The diverse array of industries and drivers of these revenues is a major benefit for CLOs, since the pools of loans that they hold are required to be comprised of many industries, potentially cushioning downsides in economic activity.

In conclusion, CLOs have historically performed better than other structured credit investments with less downside, a trend we believe will continue for the reasons discussed. Individual investors now have more opportunities to access a large variety of CLOs across a range of return profiles. CLOs, an established asset class historically utilized by institutional investors, offer attractive high-yield opportunities for individual investors.

Bluerock is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. All investing is subject to risk, including the possible loss of principal. The information contained herein is sourced from third parties and Bluerock makes no assurances with respect to its accuracy, completeness or timeliness. Past Performance is not necessarily indicative of future results.