Higher Demand for CLO Equity Helps Banks

It has taken several years and rock-bottom interest rates, but more investors are eyeing the riskiest tranches of collateralized loan obligations, known as the equity. And they like what they see.

Banks benefit from the trend because they underwrite and market CLOs, and noninvestment grade corporate loans serve as the collateral. More demand for CLO equity is feeding a rise in CLOs, which increases demand for loans.

The biggest buyers of CLOs-- most notably structured investment vehicles — disappeared when the financial crisis struck, and issuance ground to a halt. When the market sporadically recovered in 2010 and 2011, it was because some managers were able to find a small number of buyers for the least-risky, triple-A-rated tranches and hold on to the riskier tranches themselves. Most of these managers were affiliated with private-equity shops and had deep pockets.

Some deals still get done this way, especially those managed by CLO managers who lack a long track record. But it is getting easier to place the equity with outside investors, market participants say.

With issuance this year heading toward $40 billion, or three times higher than 2011, the interest in CLO equity has grown and new kinds of investors have been stepping up.

"Over the last two years, Morgan Stanley has placed $250 million of CLO equity to third party investors across more than 20 accounts," Sajid Zaidi, head of CLO structuring at Morgan Stanley, said. He was speaking at one of the six panels at Information Management Network's securitization conference in Miami that were dedicated to CLOs.

Managers of CLOs and bankers working in CLO structuring have been seeing interest in CLO equity from hedge funds and pension plans steadily increase as the market has recovered. However, now other institutional investors such as foundations and endowments, and even family offices, are jumping on board, Zaidi said.

Investors in other structured products, notably residential mortgage-backed securities, are taking a look, too. "I would be surprised if we don't see significant crossover bid," Richard Hill, a CLO strategist with Royal Bank of Scotland said on another panel. "The number of RMBS buyers that are attracted to CLOs is going to grow exponentially."

The reason for this is simple. With the Federal Reserve keeping interest rates near zero in an attempt to boost the economy, investors are on a hunt for yield, and CLO equity offers double-digit returns.

"I cannot find another asset class offering risk-adjusted returns of 10% to 12%," Hill said.

Market participants continually stressed the importance of investor education, even now.

Joe Moroney, a portfolio manager with Apollo Management who participated in one of the panels, said his firm often gets inquiries from investors interested in double-digit returns and secured collateral. "And we say, 'Oh, you want CLO equity.' And they say, 'No, no, no.' It's been a long process to educate," Moroney said.

Interest in other parts of CLOs capital structure has increased substantially, too according to market participants. For example, regional U.S. banks have an appetite for the triple-A tranches.

Spreads on new-issue CLOs, while they have tightened recently, are in the area of Libor plus 140 bps for triple-A paper (versus 150 bps during the summer).

"As most other triple-A securitized products are well inside 100 bps, CLO triple-A's offer significant value, especially in the context of bank return on equity," JPMorgan analysts noted in a Sept. 22 report.

And market participants expect the interest in CLOs to continue to grow.

"I think it will only accelerate," said panelist John Clements, a managing director at Citi. "We're going to see a snowball effect."

This story first appeared on leveragedfinancenews.com