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November 14, 2012 12:08 pm
Bundles of high-risk debt known as collateralised loan obligations were one of the exotic credit instruments that fell from favour at the start of the financial crisis, only to claw their way back to respectability. But investors may yet discover they have a sting in the tail.
Participants in this market are warning that bonds issued by CLOs before the crisis may be getting more dangerous, as managers invest in riskier assets and try to put off the day when they have to wind down their business.
The situation is particularly acute in Europe, where the collapse in investor confidence and changes to tax rules and systemic risk regulation have in effect shut the market for new CLO issuance.
CLOs are investment pools that issue bonds and use the money to buy leveraged loans, such as loans that companies use to fund acquisitions or private equity firms use to fund buyouts.
Because CLOs all come with an end date, after which income can no longer be reinvested in new loans and the fund must start to pay back investors, managers of older funds are searching frantically for ways to stay in business.
“For some of the managers under pressure with smaller funds there is a risk they are reaching for inappropriate loans to help extend the life of their funds,” says Mark Hale, chief investment officer of Prytania Investment Advisors.
“This is made more likely given how thin the supply of good quality loans is, even for managers who want to behave well.”
In Europe, as many as two-thirds of the CLO vehicles still active from the pre-crisis boom years will by the end of next year have gone “static” according to estimates from analysts, meaning their managers will be largely unable to refinance existing loans or buy new ones.
The incentive to buy as many loans as possible before then is one of several factors buoying the prices of European loans, which are up by 9 per cent this year to all-time highs, according to the S&P European Leveraged Loan Index.
Mr Hale adds that the equity holders of the CLOs, which typically include the managers, mostly have an incentive for the vehicle to run longer which, depending on what gets bought, can run counter to the interests of the senior debt holders. “The temptation can be for managers to err in favour of the equity holders,” he says.
This is helping some companies borrow more cheaply. “We have been structuring amend and extend transactions and new loan financings for our clients to take advantage of CLOs that have become heavily incentivised to buy longer-dated paper as their reinvestment periods are about to end,” said Peter Hurd, executive director, capital markets, at Nomura.
“We have executed some very attractive deals for borrowers because of this technical dynamic in the market.”
A study earlier this year by RBS found that some US CLO managers were also acting aggressively to extend the life of their funds.
Even those managers who had already passed into their “post-reinvestment” period were finding exemptions in their operating documents or asking for permission to amend them.
Richard Hill, director of CMBS and CLO strategy at RBS, says these moves to extend the duration of funds mean it could take longer than expected for outstanding bonds to be repaid, raising the risk and lowering the value of these bonds.
“The risk is that the duration of some bonds could be longer than some investors may assume,” he says.
“The language in legacy CLO documentation is often relatively loose, so there may still be significant reinvestment even after the end of the formal reinvestment period. The name of the game has become understanding these nuances in the operative documents and how managers can reinvest to their advantage.”
An unexpected revival in the CLO market in the US in recent months could alleviate some of these pressures, in sharp contrast to the situation in Europe. Instead of fighting to extend the life of their funds, several US managers have instead cut them short, buying back bonds and rolling the underlying assets into new CLOs.
Year-to-date issuance of new CLOs has been $39bn in the US, more than the total for the previous four years combined.
In fact, the risks to investors in new CLO bonds are shifting from duration worries to credit quality concerns, as new CLOs are created that have less conservative limits on the number of low-quality “covenant lite” loans they can invest in.
For investors playing the legacy CLOs in Europe, however, and some outstanding issues in the US, understanding nuanced investment rules remains key to avoiding a nasty sting.
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