Collateralized Loans Attractive, Recession Risk

There was a time when people recoiled from collateralized anything, after the real estate crash hit collateralized pools of mortgage-backed securities. Though no comparable disaster befell pools of loans, collateralized  loan obligations were nevertheless affected by fear of toxic assets.

Hence the market for CLOs froze. Recovery started in mid-2009 and strengthened last year.

Some hedge funds and institutions see certain CLO tranches as prime investment opportunity. The argument is twofold. One, the instruments are now traded more frequently—-this increase in liquidity makes it possible to value them realistically and reduces the risk. Two, certain CLO securities, in particular the equity tranches, have upside potential while the danger of default is small.

A CLO buys corporate debt, typically senior debt that has first right to company assets in case of default. Corporations are awash in cash, which cushions their senior debt. But a double-dip recession could change the picture.

CLO tranches go from triple-A rated notes that have to be paid first to lower-rated notes and equity. The top tranches are not considered good buys; it’s the lower tranches and equity that remain underpriced. Of course, if there is a recession, these carry high risk. Still, the risk-adjusted return is attractive, says a manager.

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Tags: corporate debt, double dip