Following a record year for collateralized loan obligation (CLO) issuance in 2021, issuers and investors alike anticipated a
That volatility is likely to continue. With inflation rising faster than hoped, the Federal Reserve Board is expected to raise rates more than just a few times this year. Goldman Sachs, for example, revised its forecast in January from four Fed rate hikes to five.
There are few safe investments in which to hide today, and Dan Zwirn, CEO and founder of Arena Investors, points to CLOs as among the worst. A buyside professional since the late 1990s, Zwirn founded Arena Investors in 2015 and the firm now manages upwards of $3 billion across its various funds. Its unrestricted mandate allows it to invest opportunistically across industries, products and geographies.
In a recent interview with Asset Securitization Report, Zwirn said Arena’s “free-flowing mandate” gives it an unbiased view on the strength of different investments, and CLOs are of particular concern from a risk/reward standpoint. He also shares his insights on where there is relative safety in the structured finance markets.
ASR: What is prompting your concerns?
Zwirn: Until a year ago, you could argue we were going to have a Japan-style permanent easing by the monetary authorities that would extend the inappropriate pricing of risk in perpetuity. But now, the highly profligate fiscal policy by the majority of developed countries has resulted in accelerating inflation. Arithmetically, that means either rates must move up, or inflation caused by the combination of bad monetary policy initiated in the wake of the Great Financial Crisis (GFC) and bad fiscal policy now accelerates. Therefore, for the first time since central banks overreacted in the wake of the GFC, we may have a catalyst for the appropriate pricing of risk.
ASR: The general consensus appears to be that CLOs are attractive relative to comparably rated investments, given their floating-rate structures and spread premiums. How do you respond?
Zwirn: There is undoubtedly ugly, very tight pricing from a buyer’s perspective for securitizations of unsecured consumer loans, residential mortgages and other consumer loans or other similarly homogenous and small balance-type collateral, and we’re seeing executions done above par in many instances. That’s similar to residential-mortgage and student-loan securitizations in 2007.
If you’re asking which of these is less awful than the other, that’s a tough question. With commercial real estate (CRE) CLOs, in many instances investors at least have a significant amount of subordination in the structures. So while pricing on CRE loans is probably tight, on a relative basis it’s not as tight as CLO collateral, and the structures are way less levered. If you were going to hold your nose and look for the “least worst,” I’d probably move toward non-office-heavy CRE CLOs.
ASR: What has prompted CLOs’ high leverage?
Zwirn: The sanguine perspective on CLOs stems from the GFC, when CLO equity dropped to a dime and then came back and everything was wonderful. The first flawed assumption there is that the collateral is the same, and in fact today the collateral is far more intrinsically levered and investors are far less compensated.
The second flawed assumption is more psychological: that investors can experience CLO equity dropping to a dime and then ride those investments all the way back to par, when in fact very few investors owning this equity have that institutional capability.
ASR: Do investors in CLOs’ AAA bonds fare any better? A large asset manager launched an ETF investing in CLOs’ AAA bonds that has nearly tripled in size since last summer, so investors see it as attractive. Its even newer ETF focusing on the BBB part of the stack is expected to pay Libor plus a relatively wide spread in the high 400s on a forward-looking basis.
Zwirn: That’s just wrong. Even with the horrible structures today, the AAAs will be OK, ultimately. But investors are getting grossly undercompensated for the risk they’re taking and, in fact, they’re going to make what is effectively a negative real return.
Owning a fully open-ended, ETF-style investment also introduces a whole new level of risk, because these types of securitized instruments have no liquidity when you need it—there’s no intermediation in the securitized markets to speak of. When you really need a bid, you won’t have it because dealers have very little inventory due to the cost of the capital they must hold. So, this premium for liquidity that is theoretically priced into CLOs relative to purely private assets doesn’t exist. I can’t think of anything more irresponsible to present to customers, given the asset/liability mismatch.
ASR: Does that apply to the more richly priced BBB bonds as well?
Zwirn: In addition to the ugly risk and the bad relative return, on the BBB bonds you’re now looking at a nominally investment-grade bond that is not taking into the account the attachment points within the stack on the right side of the balance sheet of the CLOs (the higher rated bonds). The BBB tranche is deeply subordinated to the pieces on top of it, and so it’s a hyper-levered return to investors.
ASR: Do your concerns about CLOs apply to most structured finance today?
Zwirn: There are parts of the securitization market—in more theoretically idiosyncratic collateral—where you can get better yields, low in the capital stack or higher up, and for shorter durations. Those investments can be compelling on an absolute basis rather than relative, and we do that for our clients in investment-grade ABS when it makes sense. But it’s not necessarily that scalable.
