CLO Selloff Flashes Warning to Junk Bond Market
By Matt Wirz, credit markets reporter
Stocks rose to fresh highs in October, often a tumultuous month for U.S. shares. One corner of the debt market had a rougher time.
Some securities in the $680 billion market for collateralized loan obligations, or CLOs, lost about 5% in October, reflecting worries about rising risk in the complex investment vehicles. The declines were a rare stumble for the CLO market, which has grown by about $350 billion in the past three years, according to data from S&P Global Market Intelligence, fueled by demand from government pensions, hedge funds and other yield-hungry investors.
“We think there’s more volatility coming,” said Maggie Wang, head of U.S. CLO strategy at Citigroup. “We recommend investors reduce risk and stay with cleaner portfolios and better managers.”
The trouble hitting CLOs could be a sign that the trillion-dollar market for high-yield bonds is also headed for a rough patch.
CLO managers buy bundles of below-investment-grade, or “leveraged,” corporate loans using money raised by selling bonds and stock to outside investors. Cash flow from the bundled loans pays interest and principal on the CLO bond with any surplus going to the CLO shareholders.
CLOs resemble the mortgage-backed bonds that imploded in 2008, but very few defaulted in the credit crisis, a key driver of their recent popularity. Prices for their shares and bonds, however, plummeted at the time, and holders who sold out took heavy losses.
Now some CLO bond prices are falling again. That’s because the riskier loans the CLOs own are dropping in value as the companies that borrowed them start running out of cash. CLO bonds rated double-B, which are among the riskiest CLO securities, returned about 10% through June. But recent declines, especially last month, erased most of the gains, giving holders a roughly 1% return this year through October.
That contrasts sharply with high-yield bonds. Many of the same companies to which CLOs lend issue junk bonds, which returned about 12% through October, according to data from S&P Global Market Intelligence.
“If you think that double-B CLOs are giving a warning sign, that says something about high yield,” said David Preston, head of CLO research at Wells Fargo. “It’s hard to see how both markets can be right.”