The best way to hedge a portfolio of collateralized loan obligations (CLOs) might just be with a new type of CLO structure. No, seriously.
Credit Suisse is taking a cue from the U.S. Treasury and mortgage-bond markets and splitting the safest portions of CLOs into two parts: one that pays only interest and another that’s mainly principal. Bloomberg News’s Adam Tempkin saw a presentation from the bank on the structure, known as Mascot, for modifiable and splittable/combinable tranches. In it, the bank argues that the interest-only portion in particular has “the potential to be the cheap hedge a bondholder can construct for a CLO portfolio.”
On its face, this looks like peak Wall Street. Spitting up CLOs, which themselves are bundles of leveraged loans, and offering them as a way for investors to protect against large declines in credit markets? Perhaps this is little more than bankers getting creative to get deals done when the alarm over growth in risky corporate borrowing is becoming harder to ignore.
Obviously, if you believe that the $1.3 trillion leveraged lending market will eventually face a day of reckoning, and CLOs will go the way of the pre-crisis CDOs, then this sort of structure is probably of little interest. However, as I’ve written before, that seems unlikely to happen for a number of reasons, even if Moody’s Investors Service considers loan covenants to be about the weakest on record. Most likely, as Bank of America Chief Executive Officer Brian Moynihan said, the economy will slow down “and then the usual carnage goes on.” A typical level of losses wouldn’t hit the top-rated segments of CLOs, which famously never defaulted, even at the heights of the financial crisis.
So credit-market bloodbath aside, this new CLO innovation might make sense after all.
The appeal of Mascot hinges on the fact that asset managers who issue CLOs can typically refinance starting two years after they sold them. This option is extremely valuable to borrowers. If credit spreads tighten during that period, they can come to market again and get cheaper funding. If spreads widen, well, they’ve already locked in cheaper funding.
On the flip side, this refinancing option is something of a lose-lose for investors because the CLO issuer will effectively do the exact opposite of what they’d prefer. Conditions that encourage refinancing, by definition, mean buyers (including life insurers) will have to reinvest at tighter spreads and accept reduced returns. As spreads widen, investors are stuck holding on to lower-yielding securities. Neither of these outcomes is detrimental, to be sure, but they can be frustrating.