Canadian government pension plan explores risky securities
CPPIB to buy equity in CLOs managed by New York’s Sound Point Capital Management
Canada’s government pension plan is investing $285 million in the riskiest securities of collateralized loan obligations, or CLOs, as large institutions start funneling more cash into a market that has received record sums in 2018.
The Canada Pension Plan Investment Board, or CPPIB, will buy equity in CLOs managed by Sound Point Capital Management, a New York-based credit hedge fund founded by former Bank of America investment banker Stephen Ketchum. It is the first such partnership for the pension, which sees CLO equity as an attractive way to boost returns on its leveraged loan investments, a plan spokesman said.
CLOs raise money by issuing bonds and equity to outside investors and use the cash to buy bundles of below-investmentgrade, or “leveraged,” corporate loans. The money coming in from the bundled loans pays investors’ interest and principal on the CLO bonds, in a process similar to mortgage-backed securitizations. Equity holders typically must cover loan losses above a certain threshold—an arrangement that accounts both for CLO equity’s risk and for its higher expected returns.
CLO equity has historically been purchased by hedge funds or private-equity firms. Purchases by large institutions such as CPPIB, with $275 billion in assets, could give CLO managers significantly more firepower to launch new deals, further boosting demand for leveraged loans and potentially adding to risk in junk debt markets. Managers can borrow about $9 million of bonds for each $1 million of equity raised to buy up leveraged loan pools.
“The asset class has increasing acceptance from institutional investors,” said Wade O’Brien,
a managing director at Cambridge Associates who advises foundations and endowments on credit investments. Cambridge is recommending clients make investments in dedicated funds that buy only CLO equity, which can return about 15% annually in typical market conditions, he said.
The increased appetite for CLOs reflects a decadelong increase in purchases of junk-rated corporate and government debt by institutional investors in response to persistently low interest rates in safer markets. Purchases by CLOs helped push the leveraged-loan market to $1.22 trillion in June, exceeding the size of the junk bond market for the first time in 10 years.
The global CLO market has grown 25% in the past two years to about $700 billion outstanding,
according to data from JPMorgan Chase & Co. Annual returns from the equity have averaged about 18% since 2004, according to research from JPMorgan, but some analysts caution that if leveraged loan defaults rise, certain CLOs will only have enough cash to keep paying their bonds, leaving equity holders with losses.
Institutional investors routinely purchased CLO bonds in recent years because they pay floating-rate interest—an advantage when interest rates are rising— and have outperformed more conventional corporate debt. CLO bonds rated single-B returned 38% in 2017 compared with 4.27% returned by comparable leveraged loans, according to data from Morgan Stanley.
CLO managers in the U.S. have raised about $100 billion so far
this year, 24% more than in the same period of 2017, according to S&P Global, and analysts expect them to issue a record $130 billion or more in 2018. Sound Point’s capital has surged by almost 70% since April 2017 to $20 billion, driven principally by its CLO team, which has 68 employees, a company spokesman said.
That demand has pushed CLO bond prices higher and their yields lower— single-B CLO bonds have returned just 5.18% this year, according to data from Morgan Stanley—making CLO equity more attractive in comparison.
Analysts at Morgan Stanley said they are wary of CLO equity because leveraged loan prices could fall sharply, especially if concerns rise that loanholders will recover less when defaults rise than in prior downturns.
Many CLOs stopped paying equity holders in 2009 but resumed payments when loan prices rebounded unlike other structured investments that were completely wiped out in the financial crisis. CLO returns averaged about 6% in 2009 and 15% in 2010, said Rishad Ahluwalia, JP Morgan’s head of CLO research. CLO securitizations fared far better than their mortgage-backed cousins in the crisis because leveraged loan defaults were far lower than in housing debt and no senior CLO bonds went unpaid.
Mr. Ahluwalia said many of the fund managers he has met with this year are mortgage securitization specialists looking to expand into CLO trading. “The CLO market has become very big,” he said. “It’s a market in its own right.”