VIEWPOINT

PIMCO Alternatives CLOs: An Acronym for Contrarian Long-term Opportunity

AUTHORS Concerns over complexity and structural late in Giang Bui the credit cycle have led many investors to overlook Executive Vice President Portfolio Manager collateralized loan obligations (CLOs). However, late- cycle CLOs have historically benefitted from tight Harin de Silva Executive Vice President borrowing spreads and an opportunity to invest in Portfolio Manager higher-yielding assets. CLOs have demonstrated their Kristofer Kraus resiliency as an class over several credit cycles, Executive Vice President Portfolio Manager with low realized principal losses for CLO debt and robust returns for CLO equity. For long-term investors, Loren Sageser Senior Vice President CLOs can offer an attractive, front-end-loaded return Product Strategist profile that may complement longer-lockup alternative with back-end return profiles.

But investors need to understand the key structural features of these complex instruments, which provide limited liquidity, contain high levels of embedded leverage and lead to a wide range of return outcomes. As the volatility experienced by CLOs in the showed, long-term investors should conduct a comprehensive assessment of credit , structural risk, manager capability and risk, and have the ability to integrate these elements into a unified framework.

This paper discusses the basics of CLO equity, provides an approach for valuation, and highlights factors that can CLO equity as a unique investment opportunity late in the credit cycle. 2 October 2017 Viewpoint

THE BASICS FIGURE 1: CLO STRUCTURE AND POTENTIAL RETURNS On the most basic level, CLOs are arbitrage vehicles. In a CLO, a special purpose vehicle issues long-term debt and equity tranches, the proceeds of which the purchase of a portfolio of floating-rate corporate bank loans. Equity tranche AAA Tranche investors are positioned to benefit from term, non-recourse ~L + 120 bps / ~63% of cap structure leverage without mark-to-market triggers. In other words, the CLO does not face liquidation or calls if the market AA Tranche value of the bank loan portfolio falls. ~L + 170 bps / ~10% of cap structure CLO equity returns are driven by the arbitrage between the cost

of the debt tranches and the interest income generated by the Portfolio cashflows portfolio of floating-rate bank loans. In Figure 1, the weighted- A Tranche ~ L + 240 bps / ~7% of cap structure average cost of the debt tranches is roughly + 173 basis points (bps). If the bank loan portfolio generates an average coupon of Libor + 350 bps, the arbitrage opportunity available BBB Tranche for CLO equity investors is about 177 bps, before deducting losses Portfolio ~L + 370 bps / ~6% of cap structure ongoing deal expenses. This arbitrage is magnified by the embedded leverage in the CLO for the equity tranche. BB Tranche VALUATION APPROACHES ~L + 610 bps / ~4% of cap structure

The primary challenge faced by prospective CLO equity investors is determining a valuation framework. One approach Equity is to think of the CLO equity return as a combination of two ~10-15% IRR / ~10% of cap structure separate return streams: an interest only (IO) set of cash flows and a principal only (PO) set of cash flows. While the total CLO equity return is simply a combination of these two sets of Source: PIMCO as of June 30 2017. Hypothetical example for illustrative purposes only. cash flows, distinguishing the two streams allows us to differentiate the sources of return for the equity tranche and the associated with those returns. Figure 2 shows an example of cash flows to a CLO equity tranche as a function of “barbelled,” with very high- and low-spread names, or is it time from initial investment. uniform? All of these factors can affect the size and stability of both the IO and the PO cash flows, driving relative value up and THE IO: A ON BANK LOAN SPREADS down the and across deals. The arbitrage between CLO debt and the underlying portfolio Adding to the complexity, CLOs are dynamic, managed assets represents the IO component of the equity return. The structures, with a reinvestment period generally spanning three starting point for evaluating a CLO equity investment is to five years and with some limited reinvestment rights even understanding what drives this arbitrage and assessing its yield after the end of the reinvestment period. Over the life cycle of a potential and risks. For example, has the manager elected to add CLO, some portion of the loans will repay and some portion will spread and risk through a larger exposure to CCC-rated bank default. Since both repayments of performing loans and loans, loans with weak covenant packages or higher exposure to recoveries from defaulted loans can be reinvested in new loans, more volatile industry segments? Does the portfolio have high equity investors are effectively long a call option on loan spreads. exposure to higher-risk middle market issuers? Is the portfolio October 2017 Viewpoint 3

FIGURE 2: HYPOTHETICAL CLO EQUITY CASHFLOWS

Principal Interest

80

60.9% 60

40

20 16.9% 16.3% 16.2% 15.9% 15.7% 11.5% 6.2% 2.6% 0.6% 0 0 1 2 3 4 5 6 7 8 9 -20 Percentage of cash flows

from interest and principal -40

-60

-80

-100 -100.0% Years after CLO issuance

The above example assumes a 2% default rate annually, 80% recoveries on defaulted assets, 25% prepayments on the loan portfolio, a purchase of 99.5 and a spread of 375 bps on reinvested assets. Source: PIMCO. Hypothetical example for illustrative purposes only.

The value of this option is driven by a number of factors, such as Data (see Figure 3). Even in spread environments that are sub loan repayment rates, default rates, recovery rates and optimal for refinancing, there will be some level of repayment reinvestment spreads and . The repayment rate is because of changes of control, liability management or other important to equity investors because it affects the arbitrage in a factors, even default. CLO, as well as the underlying composition. The reinvestment profile of the CLO portfolio is another Therefore, it is important to have an informed view of the critical determinant of the value of the IO. All else equal, turnover risk of the portfolio. widening bank loan spreads benefit equity holders. This is Repayment within a CLO deal occurs primarily due to because wider spreads allow managers to redeploy repayment underlying loan prepayment and the manager’s discretionary proceeds into higher-yielding assets, which would enhance the trading. Not surprisingly, companies tend to repay and excess spread cash flow to the equity tranche because the cost refinance when bank loan spreads tighten, an option given the of debt funding is fixed. lack of call protection covenants in bank loans. The loan This is why some of the best CLO equity tranches were issued repayment rate can vary significantly depending on spread right before the financial crisis. The reinvestment option can act level, with the trailing 12-month repayment rate ranging from as a downside for equity investors in a market-widening about 10% to 60% during the period from 30 September 2001 environment, as it allows managers to buy cheaper assets and to 31 March 2017, according to S&P Leveraged Commentary & 4 October 2017 Viewpoint

FIGURE 3: LOAN SPREADS VERSUS REPAYMENT RATES THE PO: A CALL OPTION ON BANK LOAN MARKET VALUES In addition to the IO stream, the CLO equity holder has a claim 2,500 on the market value of the bank loan portfolio, minus the par value of the CLO debt – the PO value. This residual, which is realizable when the CLO is called by equity investors or when it 2,000 matures, is generally expressed as the equity net asset value (NAV). Expected default and recovery rates are both key drivers of equity NAV, as is trading activity by the CLO manager. To the 1,500 extent the manager is able to invest in discounted bank loans that increase in value or mature at par, this gain will increase the 1,000 equity NAV. However, there is also the possibility that the

Spread-to-call (bps) Spread-to-call manager might add risk to the portfolio by buying assets that are trading at a discount due to credit issues. If the present value of 500 the IO stream is insufficient to offset the riskiness of the PO, the equity investor may determine that it is smarter to exercise the call option sooner rather than later. 0 0 10 20 30 40 50 60 70 As CLOs exit the reinvestment period, the PO value becomes an increasingly important valuation, since a bigger proportion of LTM repayment rate (%) future value depends on principal repayment of the underlying portfolio. At this stage in the CLO’s life cycle, analyzing the Source: S&P Leveraged Commentary & Data. Data covers period from 30 underlying portfolio by identifying default candidates becomes September 2001 to 31 March 2017. crucial to properly valuing the PO component. improve excess spread. In volatile markets, CLO equity tranches INVESTING LATER IN THE CREDIT CYCLE CAN BE ADVANTAGEOUS often suffer secondary market price declines due to falling CLO portfolio values and expectations of higher default rates. However, Timing is critical for CLO investors, but not always in the way the longer-term impact of higher equity cash flows due to one might think. Logic would suggest that it is inopportune to reinvestment activity can more than offset initial price invest in levered credit products late in the credit cycle. But the deterioration – especially if CLO managers are skilled enough to historical record of realized CLO performance suggests take advantage of volatile market conditions. otherwise. Since the CLO structure benefits from two features – term liabilities and the reinvestment option – deals issued at While spread widening can benefit the CLO equity arbitrage the end of a credit cycle often benefit from tight borrowing and therefore the value of the IO, the negative convexity spreads, which drive an increasingly attractive arbitrage as the resulting from limited call protection and repricing optionality credit cycle turns and the opportunity to invest in higher- common in the loan market can pose challenges in a benign or spread assets presents itself. Figure 4 demonstrates this “grind-tighter” credit environment. In this case, expectations for advantage: On a hold-to-maturity basis, deals issued in the long-lived IO cash flows can vanish when the CLO is called or two- to three-year period before the financial crisis realized the when underlying loans reprice rapidly and are reinvested at highest returns on average. significantly tighter spreads. However, these risks tend to be offset by the right of the majority of CLO equity class investors A WORD OF CAUTION to refinance the CLO’s debt tranches. In combination with the Although buy-and-hold CLO equity investors who invested implicit call on spreads baked in to the CLO structure, this prior to the crisis generally did well, today’s investors should refinancing option provides the CLO equity investor with bear two important considerations in mind: asymmetric upside to bank loan spreads. October 2017 Viewpoint 5

• During 2008–2009, valuations on CLO equity investments bottom-up credit factors as well as the top-down macroeconomic – of all vintages – were extremely volatile, in many cases environment. While the mark-to-market risk of CLO equity is dipping into the single digits. Investors forced to sell at the acute, hold-to-maturity investors can benefit from a robust and bottom of the market took heavy losses. stable return profile. Unlike most alternative investments, CLO equity cash flows tend to be front-loaded, typically providing • While CLOs are designed to withstand swings in bank loan investors with current cash and reducing cost basis early in an prices (and may even benefit from volatility), CLO equity investment life cycle. returns are sensitive to default rates. A rise in defaults can curtail distributions to CLO equity holders, as the deal is For this reason, an opportunistic CLO strategy can serve as a forced to divert these cash flows into new assets or to pay complement alongside other longer-lockup investments. Many down debt. This occurred in 2009, when many CLOs skipped long lock-up investments, such as private equity or venture equity distributions for several quarters due to ratings capital funds, generate back-end return profiles, so an allocation downgrades and increased defaults. This risk underscores the to CLO equity can smooth return profiles within broader importance of carefully assessing a manager's credit-picking alternatives buckets by providing front-end-loaded returns. A skills; a deep, robust credit research platform is a must for CLO-driven approach can also serve as an offset for higher- CLO managers. credit- investments, since it can potentially capitalize on a widening spread environment. THE CLO OPPORTUNITY For longer-time-horizon investors willing to dig deeper into Although CLOs are complex instruments, CLO equity can be structural complexity, CLOs can potentially offer attractive return boiled down into two key return drivers: a call on credit spreads potential, even late in the credit cycle. and a call on the assets of the transaction. Each of these options needs to be valued within a unified risk framework that considers

FIGURE 4: LATE-CYCLE CLOS OUTPERFORMED

Median U.S. CLO equity internal rates of return (IRR)* IRR (LHS) Number of deals (RHS) 20.0% 140

120 16.0% 100

12.0% 80

60 8.0%

40

4.0% 20

0.0% 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Vintage

*Reflects total return based on actual cash flows to investors. Source: Wells Fargo as of 30 June 2017. Past performance is not a guarantee or a reliable indicator of future results. 6 October 2017 Viewpoint

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Collateralized Loan Obligations (CLOs) may involve a high degree of risk and are intended for sale to qualified investors only. Investors may lose some or all of the investment and there may be periods where no cash flow distributions are received. CLOs are exposed to risks such as credit, default, liquidity, management, volatility, and credit risk. Investing in thebond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and strategies are impacted by changes in interest rates. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower’s obligation, or that such collateral could be liquidated. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Equities may decline in value due to both real and perceived general market, economic and industry conditions. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular , strategy or investment product. 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