Monday, October 1, 2012

Yield Hunt Pushing Funds Back Into CLOs?

Katya Wachtel of Reuters reports, They're back! Yield hunt pushes funds into CLOs, CDOs:
Fund managers are increasingly eyeing riskier exotic assets, some of which haven't been in fashion since the financial crisis, as yields on traditional investments get close to rock bottom.

Returns from investments in "junk" bonds, government guaranteed mortgage securities and even some battered euro-zone debt are plunging in the wake of global central bank policies intended to suppress borrowing costs.

In particular, the Federal Reserve's latest move to juice the U.S. economy by purchasing $40 billion of agency mortgage-backed securities every month is forcing some money managers who had previously been feasting on those securities to get more creative. The only problem is they may be getting out of their comfort zones and taking on too much risk.

"I would not be surprised if some managers are reaching outside of their expertise for a few extra basis points," said Bonnie Baha, a portfolio manager for DoubleLine's Global Developed Credit strategy.

To keep performance high, credit-focused managers are moving back into some of the risky assets that got tarnished during the financial crisis like collateralized loan obligations, or CLOs, securities cobbled together from pools of corporate loans.

But unlike the past when managers amped up returns by buying CLOs and risky "subprime" securities with borrowed money, leverage levels are remaining low at least for now.

New York-based BlueMountain Capital Management, which manages $10 billion in hedge fund and CLO assets, has become increasingly focused on more complex and illiquid structured credit. But the fund is also cautioning investors the payout on these riskier, high-yielding assets may take longer than more traditional investments.

"If you're willing to go out more into more illiquid, structured or complex trades, there's more opportunity, and potentially mid-teen returns," said BlueMountain co-founder Stephen Siderow.

BlueMountain is even venturing back into CDOs, the much-maligned investment product that became synonymous with the housing bust and the financial crisis. In March, the hedge fund, purchased a portfolio of synthetic collateralized debt obligations, from French bank Credit Agricole.

The firm's flagship $4.8 billion BlueMountain Credit Alternative fund rose about 12 percent in the first eight months of this year.

The search for yield is understandable with the benchmark 10-year U.S. Treasury at 1.61 percent and government guaranteed mortgage debt - the securities the Fed is purchasing - yielding just 1.50 percent. Even corporate junk bonds aren't so high-yield these days, with those securities yielding 6.36 percent on Friday, after hitting a record low of 5.98 percent last week.

Even seasoned investors that don't exclusively play in the credit markets are working extra hard for yield.

Many money managers remain apprehensive about the ability to generate big returns for their investors, despite the rally in U.S. stock prices this year, given expectations for weaker earnings, a global economy that remains far from buoyant and the ever-looming debt crisis in Europe. These macro-economic headwinds are problematic not just for investors in the fixed income universe, but for those who also specialize in equities, currency and commodities.

A $3 billion macro-focused hedge fund owned by Brazilian bank BTG Pactual, which was up 17.4 percent in the first eight months of the year recently told investors it is looking to "pick up additional yield."

In an investor letter, BTG's GEMM Fund said it now prefers "a cluster of higher-yielding, higher beta sovereign names that compensate investors appropriately for liquidity and credit risk" rather than "popular long-duration vanilla benchmarks."

So far this year, hedge funds specializing in securitized credit and mortgage-backed securities have benefited the most from the Fed's loose monetary policies. Hedge fund tracking firm eVestment|HFN said that as of August 31 securitized credit-focused funds were up 12 percent for the year, followed by mortgage-backed funds, which are up 10.67 percent.

One of the top performing credit-oriented hedge funds this year is MetaCapital Management, a $1.4 billion fund led by former Lehman Brothers trader Deepak Narula, which was up more than 29 percent through August.

Pine River Capital Management's $3 billion Fixed Income Fund gained more than 23 percent for the year through to August 24, while its roughly $900 million Liquid Mortgage Fund rose almost 19 percent over the same period, according to data from HSBC Private Bank.

Meanwhile, the average hedge fund was up only about 4 percent during the first eight months of the year, lagging well behind the broader stock market, which gained 13.5 percent through August.

LEANING TO LEVERAGED LOANS

Mark Okada, the co-founder and Chief Investment Officer of the $19 billion Highland Capital Management, said bank debt, CLOs, and some mortgage securities will provide the best returns in credit as the Fed continues to depress yields in the United States until the job market springs back to life.

"The government is in their market," Okada said of MBS, which has been so profitable for hedge funds this year. "The government isn't in my market buying loans and bonds."

That translates into big opportunities for Highland and other managers who have the expertise - and stomach - for such exotic securities. Of the $19 billion in assets Highland manages, $14 billion is invested in CLOs.

The firm's investments in $1.2 billion of secondary CLO assets are returning 27 percent this year, a person familiar with the firm said. Returns for the bulk of their CLO holdings could not be determined.

The issuance of new CLOs fell off a cliff in 2008 during the financial crisis, after reaching a peak of roughly $100 billion in 2007. CLO activity has slowly been ticking back up, and JP Morgan research analysts forecast $35 billion in new CLO supply this year, almost triple the $12.6 billion issued in 2011.

Highland Capital is investing in both new and legacy CLO assets.

JP Morgan fixed income analysts said CLOs are appealing because it "has become increasingly difficult to find high-single-digit to double-digit loss-adjusted yields" in the traditionally higher-yield residential- and commercial mortgage backed securities markets.

The main risk of investing in CLOs is "a broader market selloff, which would erode CLO relative value," the analysts wrote earlier this month. But those dangers are offset by the commitment of central banks to prop up global financial markets- - widely known as the "Central Bank put" - and the hunger for yield in general, they added.

If the economy were to severely weaken, CLOs could be hit hard as they were in the financial crisis by a rise in corporate defaults. Many of the loans in CLOs were sold to finance leveraged buyouts for heavily indebted companies.

"The problem with 'riskier' products is that risk - in this case, credit risk - could come back with a vengeance and manifest itself in ways that the market is largely oblivious to right now," DoubleLine's Baha emailed. "Default rates are low and due to the liquidity in the credit markets spreads have tightened considerably even in the face of mediocre to worrisome global economic data. It's like investors are thinking that nothing 'bad' is ever going to happen again."

While credit funds are indeed sniffing around more highly-levered products like asset-backed securities, CLOs and derivatives, prime brokers and traders say the demand for leverage in the form of borrowed cash from Wall Street lenders has not been high.

But with the Fed's intention to keep its zero-interest rate policy in place until at least mid-2015 and other major central banks, including the European Central Bank, flooding their economies with liquidity, that all might change.

The Fed's buying "will suck out an enormous supply of bonds from the market," said Bank of America Merrill Lynch's MBS/ABS strategist Chris Flanagan in a research note. "It is officially 'game on' in terms of access to supply."

The article above highlights one of the consequences of the Fed's QInfinity, namely, it forces credit funds to take on more risk and move into riskier structured credit like CLOs and CDOs.

According to LeveragedLoan, the CLO market is hot this year. As of May 30th, issuance has surpassed 2011’s full-year total of $12.3 billion, with $13.8 billion in the books. It now stands close to $27 billion.

Hedge funds and private equity funds have been moving aggressively into CLOs. Kristen Hauns of Bloomberg recently reported, Apollo Leads Private-Equity Firms in Gaining CLO Market Share:
Private-equity firms are gaining a bigger share of the collateralized loan obligation market, with Apollo Global Management LLC (APO) rising to the second spot in the U.S. after failing to crack the top 10 in 2011, according to Moody’s Investors Service.

Leon Black’s New York-based Apollo acquired CLOs managing about $9 billion in assets since the start of last year, and raised more than $1.4 billion of such funds in the same period, according to data compiled by Bloomberg. Apollo gained in the U.S. for deals backed by widely syndicated loans, landing behind Dallas-based money manager Highland Capital Management LP, according to data from Moody’s.

Apollo, Blackstone Group LP (BX)’s GSO Capital Partners LP and Carlyle Group LP (CG) now rank among the 10 biggest CLO managers after expanding in new areas as takeovers wane. The firms raised $5.1 billion of new CLOs and acquired managers of the funds in both the U.S. and Europe since the start of last year.

“Private-equity firms keep expanding in the U.S. and Europe,” Yu Sun, a New York-based senior credit officer in the structured credit rating team at Moody’s, said in a telephone interview. “Private-equity shops in the last couple of years have been growing through acquisition.”

In October Apollo acquired Gulf Stream Asset Management LLC, which controls 10 CLOs with about $3 billion in loans, according to an Oct. 24 news release. In April it completed the acquisition of Stone Tower Capital LLC, which had about $18 billion in assets, according to an April 2 statement.
Apollo Growth

Firms such as Apollo have capital to put into the business and help it grow, whether organically or by an acquisition, Joe Moroney, who helps run the senior credit business at Apollo in New York, said in a telephone interview.

Apollo’s assets under management rose 46 percent to $105 billion as of June 30, from $71.7 billion a year earlier, the firm said Aug. 2 in regulatory filing announcing second quarter results.

CLOs are a type of collateralized debt obligation that pool high-yield, high-risk loans and slice them into securities of varying risk and returns.

There have been $25.8 billion of CLOs backed by widely syndicated loans raised in the U.S. this year, the most since 2007, according to Bloomberg and Morgan Stanley data. JPMorgan Chase & Co. increased its CLO forecast for 2012 by $5 billion to $35 billion and said there may be $50 billion to $60 billion of the funds raised next year.

Apollo pushed CIFC Corp. (DFR), a New York-based investment firm, to eighth place this year from second in 2011, according to Moody’s. Peter Gleysteen, CIFC CEO, didn’t return a telephone call seeking comment.

Blackstone’s GSO was ranked seventh in the U.S. in 2012, down from fourth in 2011. Carlyle rose to sixth from seventh in the same ranking.
PE Advantage

New York-based GSO remains the largest manager globally by assets with $18.7 billion across 41 funds, according to Moody’s. Carlyle ranks second with $14.9 billion and Apollo eighth with $10.4 billion.

“Private-equity firms have the infrastructure, the financial capital and the human capital to be able to have a long-term oriented and growth-oriented business model in the loan and CLO space,” Linda Pace, head of U.S. structured credit at Carlyle in New York, said in a telephone interview.

Private-equity firms expanded their businesses into credit as takeovers fell, with announced deals totaling $440.8 billion in 2011, half of the $878.5 billion peak seen in 2007, Bloomberg data show.

Diversifying their revenue and profit streams is in part meant to satisfy public investors in the firms who’ve bought shares during a handful of private-equity manager IPOs in the past five years.

“It’s a good compliment for private-equity firms to have a stable asset management business that produces fee streams that are predictable,” Jane Lee, managing director at GSO in New York, said in a telephone interview.
And demand for leveraged loans is picking up in Europe where the crisis is forcing companies to rethink how they tap into credit markets. A couple of weeks ago, Nathalie Harrison of Reuters reported, Asset managers broaden leveraged finance funds' reach:
The integration between the European and U.S. leveraged loan markets, and the convergence of leveraged finance and high-yield capital markets were further reinforced this week following the announcement of more fund-raising by two major investment firms.

Babson Capital said it had raised over $1.2 billion (745 million pounds) for its Global Loan Fund in just 18 months, while Intermediate Capital Group announced a new institutional combined loan and high-yield bond investment strategy in response to demand from pension funds and other institutional investors.

Other fund managers have also recently launched new funds that incorporate both loans and bonds in order to help better manage volatile flows in high-yield and leveraged loan markets.

The strategy allows investors to benefit from the ability to invest in both asset classes depending on which has the best risk-adjusted returns at a given point in time, ICG said.

Fund managers also aim to take advantage of a gaping hole in demand for leveraged loans left by the demise of collateralised loan obligations, which are nearing the end of their reinvestment periods at an accelerated pace.

Although the creation of new CLOs has picked up in the U.S., bankers are doubtful that Europe can mirror that due to structural and valuation anomalies.

Leading leveraged finance banking teams have also adopted a global approach to capital markets in the past year due to heightened volatility in Europe compared to the deeper, more liquid, U.S. market.

That has led to a substantial amount of dollar fundraising, in both loans and high-yield bonds, by European companies. Just this week, Germany tyre company Continental priced an upsized $950 million seven-year senior secured bond with a coupon of just 4.5 percent.

Other companies, such as Spanish cable ONO, have also sought funding in the U.S., while French cable business Numericable is considering whether to tap the dollar or euro high-yield market, bankers said.

Babson Capital, which is seeking to take advantage of elevated loan spreads in both Europe and the US, claimed that the speed in which its Dublin-domiciled fund was raised illustrates the advantages of a global approach.

Babson Capital's total assets under management in global high-yield investments are approximately $27 billion, and the Global Loan Fund takes total AUM of the open-ended high-yield credit funds managed by Babson to over USD3bn, the firm said in a statement on Thursday.

EBBS AND FLOWS

Further evidence that the leading players in credit are taking an increasingly integrated approach to leveraged finance and high-yield capital markets was provided last week by ECM Asset Management.

The firm, owned by Wells Fargo, announced a new senior secured fund, which will invest in both loans and bonds to take advantage of what it expects to remain very attractive yields in Europe.

The fund will target returns of 6-8 percent and has a target size of 500 million euros (400 million pounds).

"One aim is to broaden out as much as possible the assets that we can buy, which will enable us to take advantage of the seasonal flows in both high-yield and loans," said Matthew Craston, head of alternative investments at ECM.

Market participants expect the flow of primary loan deals to ebb in the near term - following a number of pulled leveraged buyout deals including Schenck and Iglo - leaving high-yield the busiest place for new issues for this month at least.

Leveraged finance bankers said that LBO auction activity remains relatively low, with the financing of any deals in the works unlikely to hit markets until the later this year or early 2013 due to lengthy, and volatile, sales processes.

This is the first time that ECM, which has $9 billion in assets under management, has managed the two asset classes together in a single fund. ECM will still operate separate standalone loan and high-yield funds, the latter of which was only launched last year.

A fund manager that runs a bond-only portfolio said he had also been approached by investors about the possibility of including loans in the portfolio, and said it was an increasing topic of debate in the market where allocations are squeezed and high-yield supply can be sporadic.

The best opportunities are likely to be in the primary market, ECM said, as bank demand for loans remains capped by regulatory restraints on capital.
Finally, earlier this month, Danielle Robinson and Adam Tempkin of Reuters reported, Quest for yield revives hybrid loan/bond CLO structure:
The quest for yield has set the collateralised loan obligation (CLO) new issue market on fire in the US and reawakened a hybrid loan/bond animal that's been in hibernation for more than a decade.

CLOs -- which typically package leveraged loans into different slices of risk and sell them to investors as bonds with varying yields -- helped fuel the private equity leveraged buyout boom of 2006 and 2007. The instrument gave private equity firms the ability to cheaply finance loans for M&A activity via the capital markets.

Unlike real estate-linked CDOs, CLOs are underpinned by pools of corporate "leveraged" loans -- those made to low-rated companies.

Issuance in the sector peaked at nearly $100 billion in 2006, before investors fled structured finance products after the subprime mortgage debacle.

CLO issuance nearly halted in 2008, and barely re-emerged with only $1.2 billion sold in 2009 and $3.4 billion in 2010.

But as investor appetite for risk and yield returned over the last year, CLO issuance started to bounce back. Nearly $27 billion has already been issued year-to-date, exceeding the 2011 full-year total of $13 billion.

The re-emergence of the product is beginning to revive interest in riskier collateral profiles, which have not been seen since the inception of the asset class in the '90s, including larger collateral buckets for high yield and other riskier debt.

Thus GoldenTree, a leading manager of CLOs based in New York, recently completed a US$590m offering underwritten by Bank of America Merrill Lynch which has a maximum 40% bucket for high-yield bonds, second lien and unsecured leveraged loans.

The GoldenTree deal was a refinancing of an old portfolio of leveraged loans and bonds, rather than a response to demand for more aggressive structures than today's typical CLO with 90-95% of its collateral in secured leveraged loans.

Yet the fact that it found buyers has put a flag in the ground for other asset managers looking at ways to juice up their CLO returns by adding higher-yielding junk bonds.

California-based Peritus Asset Management, for instance, is trying to put together a US$300m CLO with a 50/50 leveraged loans/high-yield bonds split in collateral.

It's understood Peritus is hoping to design something with returns of equity of as high as 20%, compared with the 13-15% on today's more conservative CLOs.

"Loans have a higher recovery rate than bonds; there's no question of that," said one asset manager of high-yield bonds.

"But it doesn't seem to make sense to ignore a very significant high-yield bond market where you can get similar risk reward as you can in the loan market and probably with better yield attached."

A HARD SELL

Having high-yield bonds in a CLO is a hard sell, however, and may be extremely costly if the 250 basis point (bp) spread GoldenTree paid on its triple A tranche is an accurate guide.

Recent deals, like a US$718.9m CLO for Ares Management underwritten by JP Morgan, offered a trading spread of 150bp over Libor for the triple A portion, rising to 825bp over Libor for the lowest rated BB slice.

"Most investors much prefer loans (as collateral in a CLO) than high yield bonds," said Ratul Roy, head of structured credit strategy at Citigroup.

"Conventional CLOs have rarely ever defaulted... but of the 40 out of 4,118 tranches that did default (since the late 1990s), most were in structures that invested heavily in high-yield bonds, whose value deteriorated significantly in the stressful credit environment between 1999 and 2002," he said.

CLOs make money based on the difference between the liabilities spreads that they pay to their investors and the spreads they earn on the underlying loan assets.

Since 2010, liabilities spreads on all parts of the CLOs' capital stacks have been trending lower, although they are still wide compared to liabilities spreads on the vintage CLOs from the bull market of 2006.

Tighter Triple A spreads on CLOs, therefore, are key to making the economics of the product attractive for investors and issuers alike.

In recent months the return to equity investors has come under some pressure because spreads on CLOs tranches have remained sticky, at around 150 to 153bp on Triple A slices, at the same time as increasing demand for the leveraged loans has driven spreads tighter on the collateral.

What's more, the universe of CLO buyers is tiny compared to the leveraged loan market. Although that CLO buyer base is growing, it is still not that large, which means that CLO spreads have lagged the tightening seen in the underlying leveraged-loan spreads.

BALANCING ACT

This recent slowdown in CLO Triple A spread tightening has crimped equity investors' returns, making the prospect of potentially riskier deals containing high-yield bonds -- offering up to 20% in equity returns -- quite enticing.

One problem: The goal of juicing equity returns must be carefully balanced with the preservation of tightened Triple A spreads.

Accomplishing the successful sale of CLOs has always been a balancing act between pleasing Triple A investors and equity investors, two very different groups whose interests are not always aligned.

Without ample interest from both, a CLO cannot sell.

The GoldenTree and Peritus transactions are timely in that they may bring equity holders in the CLOs increased returns during a time when their returns are slipping, but structuring such a deal without affecting the ever-important Triple A spreads is not always easy.

Therefore, the 250bp Goldentree paid on its US$286m worth of Triple A tranches seemed a hefty price for the inclusion of its 40% higher-risk bucket.

It remains to be seen whether these hybrid CLOs can somehow keep their Triple A spreads tighter.

Securitization specialists say it might be possible, since risk can be dialed up and down in a collateralized structure by finessing factors like diversification, the number of tranches and the number of different ratings.

Moreover, the cost of including high-yield bonds in a CLO has a lot to do with the skill of the asset manager in finding the right sort of bonds that offer the same risk/reward as a leveraged loan but yield more, simply because of the dynamics of the bond market.

Hybrid structures may be able to balance increased equity returns with tightened Triple A spreads in the future. For instance, some experts argue that the wide Goldentree Triple A pricing is linked to investors' fears about bond inclusion in CLOs based on a junk-bond market of the past, which has little bearing on the quality of today's high-yield bonds.

The CLOs with high-yield bond exposure written in the late 1990s and early 2000s were caught up in a surge of defaults that peaked at around 11% in 2002.

Now default rates are around 2.8% and highly aggressive deals are the exception to the rule, CLO analysts say.
Investors should pay close attention to developments in global leveraged loan markets and the revival of hybrid loan/bond CLO structure. There is a flood of money chasing yield and many inexperienced players are entering the game.

For now, the US economy is continuing to recover, corporate default rates remain low and global central banks are providing ample liquidity to fuel credit markets, but that can all change in the future, wreaking havoc in these markets. Pension funds and insurance funds investing in this space should be very careful about who they partner up with.

Below, Chetan Modi, head of European leveraged finance at Moody's Investors Service, discusses the default risk for around 25 percent of unrated European leveraged buyout companies with debt due by 2015. He spoke with Bloomberg's Patricia Kuo on the sidelines of the Loan Market Association's Syndicated Loans Conference in London.