Learn Why the Asset Class is Often Overlooked

Often an overlooked asset class, we believe that CLO equity deserves strong consideration as a strategic allocation given its attractive historical return profile, time-tested proven structure, and potential diversification benefits the asset class can provide a broader portfolio.

 

1.  Strong historical return profile

In simplified terms, CLO equity creates leveraged exposure to senior secured loans. Historically, the asset class has provided strong returns in the form of quarterly dividends, with relatively low credit loss. As shown below, the equity cashflow return of post-crisis CLOs has averaged 14%, illustrating the current income benefits the asset class can bring in today’s low rate environment.1

2. The CLO structure is time-tested and has successfully navigated numerous cycles

Since their inception in the late 1980s, CLOs have proven themselves by successfully navigating numerous economic cycles and demonstrating an ability to capitalize on market dislocations. Structural features of a CLO such as: active management of the underlying collateral, non-mark-to-market leverage and redeployment of principal proceeds has allowed CLOs to generate historically strong returns throughout economic cycles. This is evidenced by only 6% of CLO equity investments issued from 2004-2007 having negative returns, and over 70% of these issues had double digit IRRs, despite being launched on the eve of the Global Financial crisis.2 CLO equity again proved its resiliency during 2020, where equity distributions reached a median return of 12% on an annualized basis, while weathering the COVID-19 pandemic and the volatility that came with it.3

3. Diversification benefits

CLO equity has historically provided diversification benefits when combined with both traditional and alternative investments. The front-loaded return profile of CLO equity can make it a great complement to other alternative investments. As shown below, CLO equity’s front-loaded cash flow provides investors with current cash-on-cash return, reducing the cost basis early in the investment life cycle. This results in CLO equity complementing other long-term, lock-up alternative investments with a back ended return profile such as private equity or venture capital investments, and ultimately smooth out the return profile of a broader alternative allocation.

Additionally, CLO equity has had a relatively low correlation with both conservative and risk assets alike, as shown in the table below. 

Conclusion

While the complexity and education associated with CLOs and CLO equity can prove daunting, we feel that the historically strong cash-on-cash return, time tested structure that has successfully navigated numerous cycles, and diversification benefits should lead investors to seriously consider CLO equity in today’s low yielding environment.

 
 

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About risks
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
 
The investment undertakes special risks which may lead to substantial loss. Investors are advised to consider their own financial circumstances and the suitability of the investment as part of their investment portfolio, and investors are advised to obtain all information and professional advice before making the investment.
Credit risk is the risk of loss on an investment due to the deterioration of an issuer’s financial health. Such a deterioration of financial health may result in a reduction of the credit rating of the issuer’s securities and may lead to the issuer’s inability to honor its contractual obligations, including making timely payment of interest and principal.
 
Foreign securities have additional risks, including exchange rate changes, political and economic upheaval, relative lack of information, relatively low market liquidity, and the potential lack of strict financial and accounting controls and standards.
 
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.
 
A majority of the assets are likely to be invested in loans and securities that are less liquid than those rated on national exchanges. The prices of securities held may decline in response to market risks.
 
Non-diversification increases the risk that the value of shares may vary more widely, and the investment may be subject to greater investment and credit risk than if it invested more broadly.
 
The ability of an issuer of a floating rate loan or debt security to repay principal prior to maturity can limit the potential for gains.
 
To the extent that there is concentration in securities of issuers in the banking and financial services industries, performance will depend to a greater extent on the overall condition of those industries. The value of these securities can be sensitive to changes in government regulation, interest rates and economic downturns in the US and abroad.
 
May use enhanced investment techniques such as derivatives. The principal risk of derivatives is that the fluctuations in their values may not correlate perfectly with the overall securities markets. Derivatives are subject to counterparty risk — the risk that the other party will not complete the transaction.
Leveraging entails risks such as magnifying changes in the value of the portfolio’s securities. 
Important information
 
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Sources:
1    Deutsche Bank, Intex as of February 3, 2021.
2    Wells Fargo and Intex from 2004-2006. Past performance is not a guide to future returns.
3    Deutsche Bank as of February 3, 2021.
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