Editor’s Note: Here’s another analysis of what’s going on with some of the products that life insurers have been considering using to make up for the effects of prolonged low interest rates on the life insurance policies and annuity contracts you sell.
A number of hedge fund firms have a hot product. It’s not their hedge funds.
Och-Ziff Capital Management’s investors withdrew $418 million from its hedge funds in the second quarter. Total inflow of assets under management, however, were $1.2 billion, its largest increase in assets in four years. The firm’s hot product: Collateralized loan obligations — a derivative debt investment that invests in leveraged loans and is a cousin of the type of funds that blew up in the housing bubble.
Like hedge funds, CLOs are supposed to be protected from losing money, particularly now. That’s because they invest generally in floating rate loans, which, unlike normal bonds, won’t lose money when interest rates rise. What’s more, CLOs have also had better returns than other asset classes this year, particularly hedge funds. The Palmer Square CLO Debt index was up 2.5% in the first seven months of the year, compared with 1.5% for hedge funds, according to Hedge Fund Research Inc.
As a result, CLOs, which are also managed by private equity firms as well as other more specialized debt investors, have become one of the hottest products on Wall Street, with inflows continuing to pick up this year, leaving hedge funds far behind. Just more than $69 billion in CLOs — which are like funds but raise money like bonds — were issued in the U.S. in the first half of the year, according to S&P Global Market Intelligence’s LCD. An additional $9.7 billion flowed into the credit derivatives in July. And last month, Wells Fargo predicted that U.S. CLO issuance would hit $150 billion this year, a record.
On the other hand, assets under management for hedge funds rose by less than half that, or $25 billion, in the first half of 2018, according to HFR. Hedge funds are still much bigger in total, with $3.2 trillion in assets compared with just less than $600 billion in CLOs. But the investment flows to CLOs, and away from hedge funds, turned this year. Last year, hedge funds increased their assets under management by $192 billion, more than three times the $57.8 billion increase in CLOs.
CLOs are not new. They were around during the financial crisis, and survived, even though they invest in risky loans. And when described as cousins of collateralized debt obligations (CDOs), which is true, many on Wall Street see that as an unfair tarring. Investing in corporate debt as CLOs generally do, even riskier corporate debt, is different from investing in subprime housing debt. And few CLOs appear to be based on synthetic debt, or structures similar to CDO-squareds, which were CDOs made up of the riskiest portions of other CDOs.