The market for collateralized loan obligations is headed for trouble if the biggest buyers pull back, some observers say. PineBridge Investments begs to differ.
Japanese investors, who helped lead so-called CLOs to record issuance in 2018, now face more regulatory scrutiny at home over billions of dollars in investments in the complex products. PineBridge portfolio managers Steven Oh and Laila Kollmorgen argue that while it would certainly be bad news for those structuring the deals if demand dried up, it would help existing CLOs perform better over time.
“Declining CLO issuance would end up being a positive outcome for investors in the loan market,” they wrote in a blog post dated Feb. 28. “Our fundamental outlook on the loan market is now more favorable in part due to this recent decline in demand,” which would improve loan structures, yields, and overall risk profiles, they said.
The more than $1 trillion leveraged-loan market is grappling with concerns over falling lending standards and an unfavorable shift in interest-rate expectations, escalating fears of convulsions should the big Japanese players exit with CLO demand already cooling in other parts of the world.
To be sure, recent data don’t suggest Japanese buyers are pulling back. Norinchukin Bank boosted holdings of top-rated CLO tranches by about $10 billion in the last three months of 2018. Japan Post Bank Co. and Mitsubishi UFJ Financial Group Inc. are also investors.
The presence of non-Japanese investors means that even if Japan buyers did retreat, it’s highly unlikely that CLO formation would cease completely, the PineBridge portfolio managers said. Even if it did, it wouldn’t result in selling pressure for the loan market because CLOs are effectively closed-end vehicles.
They also dismissed worries about any meaningful increase in corporate defaults if CLO demand wanes, saying such a scenario would require a recession that also shut down the high-yield bond market.
Compared to last year’s record of about $130 billion of CLO issuance, Oh and Kollmorgen say a range of $60-90 billion would be “more optimal” for the loan market in order to keep demand in balance with potential supply.