Junk Loans Shine as Investors Pile Into Riskiest Parts of CLOs

Investors are scoring big gains in the riskiest parts of the $3 trillion market for junk-rated corporate loans. 

The lowest-rated securities tied to what Wall Street calls collateralized loan obligations returned more than 29% this year through August, including interest payments and price changes, according to a recent report by Citigroup. That beats a 21.5% return on the S&P 500 over the same period. 

CLOs are bundles of junk-rated loans, packaged into slices of securities, that pass on interest payments to investors in order of risk. Investors in the riskiest portions, known as CLO equity, get paid last but profit when loan prices rise. They may also receive monthly cash payments based on the difference between the interest earned from loans, management fees and payments to holders of higher-rated securities. 

The high returns offered by CLO equity securities are helping attract more investors to the $805 billion market for U.S. CLOs—the largest buyer of junk-rated loans. These so-called leveraged loans are often issued to help finance private-equity buyouts of companies with significant debt relative to their earnings, or leverage.

Asset managers including Blackstone Inc. and PGIM Inc. had sold more than $131 billion worth of new CLOs this year, as of Oct. 4, according to S&P Global Market Intelligence’s LCD. That surpasses the previous full-year sales record of $128 billion set in 2018. 

Analysts expect that strong pace to continue, supported by the economy’s recovery and investors’ demand for CLOs’ relatively high yields. Asset managers including Kayne Anderson and Neuberger Berman have raised hundreds of millions of dollars this year from high-net-worth individuals and institutional investors for private credit funds that will invest in CLO equity. 

At least 16 new funds that invest in lower-rated CLO securities had debuted as of Sept. 16, according to Citi. 

“We have seen a lot more interest in CLO equity than in recent years,” said Young Choi, partner at King Street Capital Management, which manages and invests in CLOs.

Even safer CLOs are offering higher yields than other debt. Triple-A-rated CLO securities had returned 1.2% to investors this year through the third quarter, counting interest payments and price changes, according to Bank of America. That beats a minus 1.1% return on investment-grade corporate bonds and a minus 2.7% return on Treasurys over the same period.

Double-B-rated CLO securities returned 8.1% to investors through September, beating a 4.7% total return on speculative-grade corporate bonds and 4.4% on leveraged loans.

‘Now people are realizing that this is a different asset class entirely.’

— Michael Kurinets, chief investment officer at Capra Ibex Advisors

BofA analysts recently increased their forecast for new CLO sales this year from $140 billion to $165 billion. Meanwhile, the number of outstanding bank credit lines for managers putting together new CLOs has topped 100, analysts say, a sign this year’s record sales pace can continue. 

U.S. banks and insurance companies are among the institutional investors that have stepped up CLO buying in recent years. Around $130 billion in CLO assets were held by banks at the end of the second quarter this year, according to data compiled by BofA, up 35% from the start of the year. Banks typically invest in highly rated CLO bonds due to capital requirements.

Last year, insurance companies increased their holdings of CLO securities to $193 billion, up 23% from the end of 2019. These firms held around 26% of outstanding CLO securities at the time, and around 12% to 14% of equity and double-B rated securities.

The demand has allowed managers to lock in lower financing costs than in years past, analysts say. That can help widen the difference between the costs of managing the portfolio and total cash returned to investors, making CLO equity securities relatively attractive, said Mr. Choi. 

“The equity arbitrage has looked better than it has in a long time,” he said.

The growing investor base has helped improve market liquidity, or the ability to trade without moving prices significantly, for the lowest-rated securities, said Michael Kurinets, chief investment officer at Capra Ibex Advisors, which manages $4.7 billion in assets and invests primarily in CLO equity. 

“A dozen different [traders] will now put up bids for CLO equity from seasoned deals, which take some work to go through and analyze, and they’ll be within a narrow range,” he said. 

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One key investor in CLO equity: CLOs themselves. Many CLO managers will buy equity securities from their own deals, sometimes paying more than others would to help complete a deal, which earns them fees. That provides some assurance to investors that managers will swiftly deal with any problem loans in the portfolio, analysts say.

Multiasset investors have often drifted into CLOs looking for yield, before selling at first indication of trouble, said Mr. Kurinets. Now investors including hedge funds and closed-end funds have become more familiar with the risks involved, helping reduce swings. 

“We used to spend a lot of time explaining the difference between CLOs and collateralized debt obligations,” he said, referring to the investment vehicle famous for helping spark the 2008 financial crisis. “Now people are realizing that this is a different asset class entirely.”

Write to Sebastian Pellejero at sebastian.pellejero@wsj.com

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