Third quarter 2020 Collateralized loan obligations: finding opportunity amid uncertainty

Himani Trivedi In the years leading up to 2020, many market- Head of Structured Credit watchers pointed to signs of overheating in the corporate credit markets and were predicting an Loren Sageser imminent collapse. Collateralized loan obligations Alternative Credit Product Specialist (“CLOs”), which are leveraged pools of floating- rate corporate debt (commonly referred to as bank loans), were viewed by many as the poster child for the market’s excesses. Confused with subprime HIGHLIGHTS collateralized debt obligation (CDOs) that triggered • Collateralized loan obligations (CLOs) have the Great Financial Crisis of the last decade, the been resilient through previous periods of headlines suggested that CLOs would be the cause of market uncertainty. the next recession. In short order, it was predicted that CLOs would crack under the strain of a broader • Structural features and attractive fundamentals market unwind, leading to losses – and painful make CLOs a compelling investment opportunity lessons – for yield-hungry investors. in the current market environment. Driven by pandemic-panicked selling in March • CLOs offer many advantages, but today’s 2020, credit markets lurched downward, and it uncertain economic environment, higher levels appeared that the day of reckoning had finally of leverage and other complexities warrant arrived for CLOs. New issuance came to a halt, partnering with a skilled manager to build prices of CLO instruments plunged and a wave of diversified portfolios and navigate risks. rating downgrades began to strain CLO portfolios.

However, the much-anticipated shattering of the CLO market has not come to pass and CLOs did not cause the next recession. The initial panic selling self-corrected in one of the quickest rebounds the CLO market has ever seen. As quarterly earnings outperformed dire predictions and governments and

OPINION PIECE. PLEASE SEE IMPORTANT DISCLOSURES IN THE ENDNOTES. NOT FDIC INSURED | NO BANK GUARANTEE | MAY LOSE VALUE  Collateralized loan obligations: finding opportunity amid uncertainty

central banks have aggressively intervened, prices which has successfully weathered market swings of bank loans have recovered. As a result, CLO debt and liquidity crunches since the mid-1990s, spreads have returned to almost pre-pandemic levels continued to demonstrate its strength even during and CLO portfolio losses have generally stabilized. this unprecedented economic shock. Today, market This rebound across all asset classes has been largely conditions point to a potentially opportune moment driven by extraordinary measures from the central to put money to work in this battle-tested asset class. banks seeking to reflate risk appetites through seemingly unlimited quantitative easing. In the CLO space, the resiliency of the CLO structure,

What is a CLO?

Collateralized loan obligations (CLO) are highly diversified, actively managed portfolios of first lien, senior secured loans with non-recourse, non-mark to market (MTM) leverage.1

Typical companies CLO loan assets CLO liabilities & equity2 held in a CLO portfolio Principal & interest AAA-rated notes: 63% of structure

AA-rated notes: 12%

Actively A-rated notes: 6% managed portfolio of BBB-rated notes: 5%

senior loans Cash flows

BB-rated notes: 4%

CLO equity: 10%

Source: Nuveen

• A CLO borrows money (liabilities), it invests in collateral (bank loan assets) and has residual value (equity).

• CLO equity investors profit from any gains on the CLO’s loan positions as well as from the cash flow arbitrage, generated by the difference between the yield on the collateral (loans) and cost of financing for the liabilities.

1 Some broadly syndicated loan CLOs may include up to 10% second lien senior secured loans. CLOs have credit event triggers that may have MTM impacts. 2 Illustrative CLO structure.

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CLOS HAVE SHOWN RESILIENCY IN coverage tests are passing, CLOs can resume TIMES OF MARKET STRESS paying out distributions to equity investors.

CLOs borrow money from the debt markets to purchase pools of bank loans. Yet despite the INVESTING IN CLO EQUITY: THE TIME levered nature of their underlying portfolios and IS NOW the complexity of their structures, CLOs have shown resiliency in the face of market swings for Despite the market’s impressive bounce back several key reasons: since March, there are several reasons that the current environment supports investing in the 1. Term structure: First and foremost, CLOs are equity of CLOs: closed-end vehicles and generally have 11 to 13 year terms that preclude interim liquidity. • Upside potential: Bank loans have largely CLO-issued debt is available for the full term rallied from the lows of March and April, but of the vehicle and is not generally subject to given the challenging economic outlook since forced liquidation, even if market values in the the onset of the coronavirus, most still trade underlying portfolio go to zero. As a result, CLO at a discount to par (Figure 1). However, it is portfolios are well-insulated from swings in reasonable to expect that the vast majority of market valuations. bank loans will ultimately repay at par, either at maturity or when they are refinanced. For CLO 2. Diverse portfolios of senior secured bank equity investors with leveraged exposure to bank loans: The proceeds from debt and equity issued loans, this “pull to par” trend could generate by CLOs are used to purchase bank loans, which impressive return upside. are generally secured and have first lien claims in a company’s capital structure. A CLO’s strict rules • Relatively low financing costs for new enforce minimum ratings quality and require CLOs: Demand for yield is stronger than ever minimum levels of portfolio diversification, as central banks have used every tool at their greatly reducing concentration risk among disposal to push rates to new lows. Investors have industries and individual companies. also realized that there has never been a default in AAA/AA-rated CLO debt, and have driven 3. Active management: Traditional CLOs are spreads on these instruments down to pre-COVID actively managed for the first 3 to 5 years after levels. As a result, today’s CLOs have been able they are issued. This gives managers the ability to lock-in highly attractive financing rates, which to swap out of bank loans that may have become accrue to the benefit of equity investors. riskier since they were initially purchased, or to purchase out-of-favor bank loans that may be undervalued. Figure 1: Despite rallying sharply since March, bank loans still trade at a slight discount 4. Structural “guardrails” in place: While CLOs generally ignore swings in the market value 15% of the underlying bank loan portfolio, they are 1% sensitive to realized losses resulting from defaults 5% or distressed sales and unrealized credit risks. If losses exceed a pre-determined threshold, % Indeed interest income from the bank loan portfolio 5% that would have otherwise been paid to equity % or other junior debtholders is used to gradually pay down the CLO’s principal debt, starting with 5% the most senior debt. Once leverage has been Dec 1 ar 2 un 2 ep 2 reduced to more manageable levels and asset Source: Bloomberg.

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Addition of LIBOR floors: LIBOR has fallen equity investors to partner with a manager who can precipitously year to date. As a result, most not only build diversified and resilient portfolios, but new bank loans issued today come with LIBOR who can prudently add risk when warranted. floors, which set a minimum coupon level. As an While a CLO’s financing costs are effectively locked example, a bank loan with a coupon of LIBOR in for the life of the vehicle, CLO equity investors plus 4% might have a LIBOR floor of 0.5% to can actually benefit if credit spreads increase 1%, meaning that if LIBOR falls below the floor over time because CLOs can actively reinvest into (3-month LIBOR currently stands at roughly higher spread bank loans, potentially increasing 0.22%) the effective coupon paid by the bank the cash flow paid to equity investors. Of course, loan is 4.5-5%. In a low rate environment, this this benefit can be diminished if the CLO portfolio benefits CLO equity investors because debt sustains losses due to defaults and trading activity, issued by CLOs is not subject to LIBOR floors underscoring the importance of investing with greater than zero. Effectively, the CLO equity a skilled manager capable of preserving value in investor can earn the spread between the LIBOR challenging market conditions. floor and actual LIBOR. On a levered basis, this can produce meaningful return benefits. In the months immediately after the coronavirus began to roil markets, our CLO investment team recognized the need to reduce risk and capture THE IMPORTANCE OF MANAGER potential upside opportunities. As we assessed the SELECTION new economic reality imposed by the pandemic, we began to gauge the demand outlook during CLO equity investments have many advantages, the shutdown phase during late spring/early but there are also investment risks, making CLO summer and during the re-opening phase that equity investors highly dependent on experienced followed. We categorized companies according to CLO managers. In today’s uncertain economic the expected change in demand for their services environment, the prospect of credit losses is very over time and identified potential sector winners real, and skilled CLO mangers can help avoid (e.g., home improvement, drive-thru restaurants) realized losses that may occur through either and losers (e.g., theaters, fitness) over the short- through defaults or trading. Given the relatively high and medium-term. levels of leverage in a CLO, it is important for CLO

COVI shtdown Reoening hase

Demand for services and/or goods Baseline demand

T Thematic outlook (+) Outlook (+) Outlook Home improvement Advertising Accelerated essentials Lost demand Drive-thru restaurants Theaters non-essentials Road mobility Indoor activities Accelerated essentials Groceries/Pharmaceuticals Fitness Lost demand essentials Elective surgeries Airlines Deferred essentials Outpatient services Structural losers Pre-coronavirus stressed LBOs Stable demand Communications Outdoor activities Structural winners Technology

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CLOs are subject to numerous portfolio restrictions SEIZING THE OPPORTUNITY that are intended to serve as guardrails protecting debt investors, but CLO managers with deep Although CLOs are often viewed with apprehension expertise navigating these criteria can skillfully due to their embedded leverage and high reposition portfolios and produce better outcomes complexity, 2020 has once again highlighted for both debt and equity investors. As markets their ability to successfully withstand high levels have stabilized and forward-looking visibility has of market volatility. We believe the current improved, we believe CLOs are well-positioned to market environment represents a compelling weather future bouts of volatility while benefiting opportunity for potential CLO equity investors, from steadily improving market conditions. as low CLO financing rates and discounted bank loans converge to produce a potentially attractive arbitrage. In addition, investors who are able to invest alongside CLO managers as majority owners of the equity tranche can further improve return outcomes through greater alignment of interest with the manager.

We believe CLOs are well-positioned to weather Nevertheless, the levered nature of CLO portfolios and the complexity of the CLO structure warrant future bouts of volatility while benefiting from appropriate levels of caution, and underscore the steadily improving market conditions. importance of partnering with a skilled manager with a robust platform and significant alignment of interest. Proper due diligence is key, because the right manager can enable a CLO equity investor to capture upside opportunities while mitigating downside risk.

5 OPINION PIECE. PLEASE SEE IMPORTANT DISCLOSURES IN THE ENDNOTES. Nuveen AssetManagement,LLCisaregistered investmentadviserandanaffiliateofNuveen,LLC. by theInternalRevenue Serviceorstatetaxauthorities,noncompliantconductofabondissuer. taxes, based on state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative gain/ minimum to tax subject (AMT) are and/or maturity,securities state to municipal and prior local sold If portfolio. their in investments tax-exempt of suitability the regarding professional tax their contact should Clients risk, includingthepossiblelossofprincipal.Thevaluetheportfoliowillfluctuatebasedonunderlying securities. An investment in any municipal portfolio should be made with an understanding of the risks involved in investing in municipal bonds, such as interest rate risk, credit risk and market or affiliation withNuveenrespecttoanyresourceprovided. sponsorship, authorization, endorsement, an constitute not do and courtesy a as provided are Resources judgment. own their of exercise the for substitute a as recipients by This reportisnotintendedtoconstitute an offer, solicitation,recommendation oradvice regarding anysecurities or investment strategy. This information shouldnotberegarded from thirdpartysourcesbelievedtobereliablebutarenotguaranteedasaccuracyand necessarilyallinclusive. constitute views and opinions All advice. information contains report This notice. planning without time any at superseded or outdated financial become may information such and writing or of date the of as information tax, relevant or judgments legal, specific as construed be not should and only purposes information general for provided is report This A wordonrisk subject tochangeatanytime,whichcouldmateriallyaffecttheinformationprovidedherein. Taxcircumstances. personal your regarding professional tax or are legal regulations personal IRS your and with rates consult Please advice. tax or legal provide employees their or or investment decisions. This information should not replace consultation a with client’s a financial professional regarding their tax situation. Neither Nuveen nor any of its affiliates tax any making before advisor. professionals tax financial a their not consult is should LLC Clients Management, Asset Nuveen information. tax general provides commentary This or completenessof, norliabilityfor, decisionsbasedonsuchinformationanditshouldnotberelied onassuch. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability information the on impact material presented hereinbywayofexample. a have could material this preparing in made been have may that assumptions to changes Any composition. portfolio expected or proposed and returns, market of estimates forecasts, projections, things, other among include, may information Such nature. in historical purely not is that information “forward-looking” numerous factors,suchasmarket orotherconditions,legalandregulatorydevelopments,additionalrisksuncertaintiesmaynotcometopass.Thismaterialcontain on based time any at notice without change may and production/writing of date the of as only purposes educational and informational for are expressed opinions and views The objectivesandcircumstancesinconsultationwithhisorherfinancialprofessionals. specific course ofaction.Investmentdecisionsshouldbemadebasedonaninvestor’s any suggest investor, or particular any of circumstances or objectives specific the account into take not does provided information capacity. The fiduciary a in provided This materialisnotintendedtobearecommendationorinvestmentadvice,doesconstitutesolicitationbuy, sellorholdasecurityaninvestmentstrategy, andisnot Endnotes The CreditSuisseLeveragedLoanIndex Glossary nuveen.com. visit please For more information, Past performanceisnoguaranteeoffutureresults. is designed to mirror the investable universe of the $US-denominated leveragedloanmarket. isdesignedtomirrortheinvestableuniverseof$US-denominated Past performanceisnoguarantee offutureresults. Investinginvolvesrisk;lossofprincipleispossible.

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