Are Pension Funds Fiddling With Another CLO Time Bomb?

Laura Benitez and Nishant Kumar of Bloomberg report hedge funds draw pension money to riskiest corner of a $1.3 trillion credit market:

A high-stakes trade in the riskiest corner of a $1.3 trillion credit market is enticing some of the world’s most conservative investors, raising concerns that in their aggressive hunt for higher yields they may be discounting some pitfalls.

Pension plans and insurers have been piling into funds that invest in equity tranches of collateralized loan obligations in recent months, according to several asset managers who spoke on the condition of anonymity. The inflows have helped a slew of hedge funds and other money managers, including GoldenTree Asset Management, Sculptor Capital Management, Carlyle Group Inc. and CVC Credit Partners, to raise at least $3.1 billion in less than a year for strategies solely dedicated to these investments.

CLO equity — a small slice of the resurgent market for CLOs that bundle leveraged loans into bonds with varying safety ratings — is actually a form of deeply subordinated debt. It’s highly risky because it’s last in line to receive payments and the first to take any loss. Yet it has an appeal because of its greater claim to profits depending on the strength of the underlying collateral. It promises returns as high as the mid- to high-teens

While investors have typically included other hedge funds, family offices and sovereign wealth funds, the prospect of higher yields is now luring more money that’s been traditionally risk-averse. The recent increase in demand from pension funds adds a potentially large buyer to the mix and these CLO equity pools, which were harder to raise earlier because of the inherent risks, are getting bigger.

Those raising CLO equity funds say the risks are well flagged, but some investors are concerned that pensions flocking to these investments may be taking on too much risk for returns that haven’t always lived up to expectations. 

New York-based Dan Zwirn, founder and chief executive officer of Arena Investors LP, an institutional manager overseeing more than $3.5 billion in assets, said the attraction of low default rates for leveraged loans, estimated at 1.5%-2% by Bloomberg Intelligence, may be masking the asset class’s broader drawbacks.

There’s this “pretend notion that because default rates are low, everything’s fine,” Zwirn said. “But it’s not about defaults, it’s about recoveries and actual losses and that’s what people miss.” 

Zwirn said default rates are low because creditor protections have deteriorated over the years, making it harder for borrowers to breach debt terms and trigger a default. Recoveries for high-yield bonds and loans on a last-twelve-months basis have fallen to 33.1% and 41.7%, respectively, from their 25-year annual averages of 40% and 63.5%, according to JPMorgan Chase & Co.

“There’s a lot of extending and pretending, as well as ‘liability management exercises,’ which means that pain is being pushed out, and recovery levels are going to be much lower than expected,” Zwirn said. For returns in the low-teens, CLO equity actually has a terrible risk-reward, he added.

CLO Resurgence

The market for CLOs is coming back to life after languishing for much of the past two years due to a weak economic environment. Sales of new US CLOs have surged 64% this year from the same period in 2023, according to data compiled by Bloomberg News.  

Pension inflows into CLO equity, for which no public estimates are available due to the opaque nature of the strategy, aren’t entirely new. Canada Pension Plan Investment Board was present as far back as 2018. Recently, however, there’s been a growing interest from others as well, according to Loic Prevot, who manages CLOs as the head of European leveraged credit at Polus Capital Management.  

GoldenTree, which beat its target to raise $1.3 billion to invest in first-loss equity tranches of CLOs, received reverse inquiries from some investors and won backing from existing as well as new investors, including pensions, according to a person with knowledge of the matter. The strategy “optimizes returns in both volatile and benign environments,” Chief Executive Officer Kathy Sutherland said. Sculptor, Carlyle, CVC and CPPIB didn’t respond to requests seeking comment.

Alternative investment platform Sagard and CLO manager Irradiant Partners LP have also raised CLO equity funds in the last year, Bloomberg News has reported previously.

The so-called total arbitrage, a key metric that’s an indicator of the net income for CLO equity, has shown a premium of more than 200 basis points over the last six months. If that stays, more funds will continue to chase the strategy, according to Mahesh Bhimalingam, chief European credit strategist at Bloomberg Intelligence.

Europe Regulations

There’s been a historical aversion to CLO equity because of the negative sentiment toward securitized products following the global financial crisis, but the asset class has performed well over the years, including during periods of heightened volatility, said Polus Capital’s Prevot. Newer entrants do have an understanding of the risk profile and how it fits into their investment strategies, he said. 

In Europe, insurers and pension funds are restrained by regulations on how much they can allocate to these higher risk strategies. As a result, their direct participation has historically been quite low, according to Dan Robinson, head of alternative credit for Europe, the Middle East and Africa at Deutsche Bank AG’s asset-management arm DWS Group. 

They “can’t be casual about investing into CLO equity,” Robinson said. “For example, there can be deep draw-downs and market liquidity has been volatile for first-loss pieces.”

Pension funds looking for beefier returns place bets not just on the broader market swings but also on the manager who can better select the individual loans that get bundled up. 

Some money managers have exceeded expectations, helping stoke such interest in the product. For instance, CVC’s €400 million ($431 million) European leveraged loan fund launched last year achieved a 47% internal rate of return.

But that doesn’t mean all funds would be able to mitigate potential losses on loan portfolios to deliver attractive CLO equity returns. 

Craig Bergstrom, chief investment officer at New York-based Corbin Capital Partners that invests in credit funds, says that these strategies have returned only around mid- to sometimes high, single- digit annualized returns over the last eight years across the industry, amid bouts of high market volatility. The business will largely likely come under pressure if investors aren’t eventually paid for the risks, he added.

A lot of big owners are going to wake up one day and ask “Wait! We’ve taken 10 times levered first-loss risk in an OK credit environment and we’ve made 6% or 8% returns?” said Bergstrom.

The article ends discussing how CVC's European leveraged loan fund achieved an IRR of 47% last year and then Craig Bergstrom, CIO of Corbin Capital warning a lot of pension funds are underestimating risk and will wake up one day saying: “Wait! We’ve taken 10 times levered first-loss risk in an OK credit environment and we’ve made 6% or 8% returns?”

Welcome to equity tranches of collateralized loan obligations, an obscure part of the market that scares the hell out of investors and brings back haunting memories of the 2008 GFC when Wall Street banks toppled over each other to securitize crappy mortgages, credit agencies slapped a AAA credit rating on them, and then banks turned around to sell these toxic products to global pension funds, sovereign wealth funds, insurance funds and anyone else grasping for "safe" yield.

What? You think meme stocks are the only dumb, outrageous thing going on at Wall Street?

Credit markets are much bigger than stock markets which means they attract all sorts of investors, mostly good but some very dubious ones too.

And it's not the elite funds named in the article that I worry about. GoldenTree Asset Management, Sculptor Capital Management, Carlyle Group Inc. and CVC Credit Partners all know what they're doing in this space.

It's the Johnny-come-lately funds, the new entrants taking dumb risks to achieve extraordinary returns that are going to get massacred when a credit event occurs.

Luckily, CPP Investments which is aiming to nearly double its credit investments over the next five years deals with top credit funds who know how to structure their loan portfolios to mitigate risks.

It doesn't make them impervious to credit events, just makes them a lot wiser.

And let's be clear, structured credit is only a small part of CPP Investments' Credit portfolio.

Andrew Edgell, Head of Credit Investments stated this to Paula Sambo of Bloomberg:

A revival in the market for collateralized loan obligations could provide another boost to deal activity, Edgell said. New-issue CLOs have increased 53 per cent compared with 2023, Bloomberg News reported last week. “CLOs are being issued again, which improves the LBO math,” Edgell said.

CLOs are divided into tranches, with the senior portion rated as investment grade, the mezzanine part below that and an equity slice making up the riskiest layer. Big buyers of the senior tranche — typically more than 60 per cent of the instrument’s structure — had backed off for a while, given their ability to lock in rich yields from more vanilla debt instruments.

Still, without a lot of LBO activity yet, lenders are “clamoring” to compete for the transactions that come up, Edgell said. As deal flow increases, “we’ll get to a more natural balance and you won’t have lenders having to do silly things,” he said.

Competition among lenders is bringing down spreads for issuers in general, even if the total cost of borrowing is still elevated due to high interest rates, Edgell said.

Issuers that are only concerned about price may choose between private credit and other sources of capital, he said. The best private credit managers however will develop long-term relationships with sponsors and earn loyalty from issuers that may be willing to pay a little bit more in return for flexible loan terms, he said. 

“It’s more fit-for-purpose for their business plan. And they know that if something goes sideways, then they know who they’re dealing with,” Edgell said. “They know they’re dealing with a partner that has capital.”

The potential risk in private credit is concentrated in smaller firms that haven’t been around for long, he said. But, he said he doesn’t see any systemic risks in the asset class.

“One thing to keep in mind is the move to private credit is actually a great thing for the capital markets because it matches the assets with a more suitable liability. And even when there’s leverage used, it’s very little leverage,” Edgell said.

So, as always, take any article that warns of pensions clamouring to get into risky equity tranches of CLOs with a grain of salt.

Some pension funds like CPP Investments (PSP and others) are a lot more sophisticated and know where and with who to take these risks.

Others who are clueless and are chasing yield, well, they're going to get their head handed to them just like retail investors chasing after GameStop, AMC, Koss Corp and other meme stocks.

The market is ruthless to dumb risk takers, it's that simple.

Anyway, those of you who want to delve more deeply into CLOs, I suggest you read this recent comment from KKR, it's excellent.  

Just remember this, smart credit managers are always thinking of mitigating downside risk, not maximizing returns by cranking up the risk.

Below, Joshua Easterly, Sixth Street Co-Founding Partner, Co-President and Co-CIO defends the safety of private credit and talks about the gaps it can fill.