The sell off in the market for high yield debt, or junk bonds, is now hitting a type of structured bond that is similar to the the type that blew up in the financial crisis. Prices of the riskiest portions of collateralized loan obligations (CLOs) have fallen 50% as of the end mid-December since mid-year, and are now trading at $0.25 for every dollar that investors have put in the structured bonds.
They’re not alone. Recently a number of credit funds have halted investor redemptions and announced they were liquidating, including a mutual fund at Third Avenue Capital. Part of the problem is the bust that is going on in the junk market due to the drop in oil and gas loan prices. Energy companies make up a significant portion of market for risky corporate debt.
Market participants have focused on nuances in the Third Avenue funds and others that have run into problems, including the fact that they were invested in the lowest-rated junk bonds, and that many of the bonds that they held were hard to trade. That seems to suggest the problem is isolated to a few funds, and the market has changed since the days of other failures like Long Term Capital Management in the late 1990s and the Bear Stearns’ funds that set off financial crisis.
But the fact that investors are selling CLOs suggests problems in the bond market are deeper than some might suspect, and are raising parallels to the financial crisis.
CLOs are a close cousin, and have a similar structure, to collateralized debt obligations (CDOs), which became one of the chief financial villains in the housing bust and play a staring role in Michael Lewis’ The Big Short. Like CDOs, CLOs buy up riskier debt, bundle those loans together, and then slice that debt up into bonds for investors with varying risk levels. Investors in the lowest-rated piece lose their money first, and so on.
The big difference between the CDOs that blew up in the financial crisis and CLOs is what they invest in. CDOs piled into mortgage backed securities. CLOs largely stick to debts of riskier companies, or leveraged loans. CLOs did initially have losses after the financial crisis. But most investors who stayed invested in CLOs ultimately posted decent returns. As a result, it was assumed that CLOs somehow were better structured than CDOs and that’s why they didn’t have problem. Since the financial crisis, investors have bought up $275 billion in CLOs. Last year, investors purchased $124 billion, nearly a third more than the previous peak in 2006.
But it could just be that during the financial crisis CLOs were not invested in the eye of the storm. That’s not the case now.
Still, CLOs do appear better able to weather the current troubles than Third Avenue or other mutual funds. Hedge manager Carl Icahn and others have warned that the problem with junk bond funds and ETFs is liquidity. The funds promise investors can redeem their stakes in the fund whenever they want. But to pay back investors, the funds have to sell their holdings. Bonds and bank loans, especially the riskier kind, often don’t trade as readily as stocks. As investors seek to sell when prices are falling, debt managers become trapped. They either don’t have the cash to payout, or they end-up liquidating investments for any price they can get.
CLOs are safer than other funds in many ways. First of all they trade like bonds or stocks. When the holder of a CLO seeks to sell a stake, managers don’t have to offload assets to pay the investor back. Instead, they must find another investor to buy that stake. This keeps the manager of the CLO from having to sell holdings as prices drop.
CLOs also hold cash. Typically about 10% of the structure is an equity investor, who buffers the first losses of the fund. CLO funds will also stop making cash payments when their underlying loans are troubled.
The trouble for CLOs, however, is that the structure adds leverage that quickly chips away at protections. When debt prices fall, losses are exacerbated. And the lowest-rated pieces of CLOs, which are supposed to provide protection, only make up about 10% of the deals. Once that is wiped out, the portions of the CLOs that were supposed to be safe investments start losing money as well. And it isn’t just original lender that is on the hook. CLOs have spread the risk of leverage lending to many more investors than in the past, even if they don’t know what they have actually gotten into.
Like LTCM and Bear Stearns, this has the potential to cause contagion.