Note

Resetting the opportunity in CLOs

Why these structured credit investments deserve a second look, even in today’s tight spread environment

Kara O’Halloran
March 10, 2021 | 8 minute read

Collateralized loan obligations (CLOs) were back in the spotlight for much of 2020 as, once again, many pundits called for their demise. But for the second time in as many major market crises, CLOs weathered the storm. As markets globally continue to heal from the pandemic, we still see opportunity in this structured credit investment.

CLOs, which are investments backed by pools of corporate loans, sold off alongside broader markets in February and March 2020. Many pointed fingers at the time, rehashing old arguments equating CLOs with other structured credit investments that played a lead role in the 2008 financial crisis: mortgage-backed securities (MBS) and other collateralized debt obligations (CDOs). Shortly thereafter, we wrote about the merits we saw in CLOs in our report, A CLO-ser look at structured products. We highlighted how CLOs are specifically designed for environments like we saw last March. They are rarely forced sellers and have implicit and explicit investor protection mechanisms. Furthermore, their underlying holdings are transparent to investors and the CLO itself is actively managed by a manager incentivized based on the performance of the deal.

Since then, CLOs have staged a remarkable recovery. Each tranche ended the year firmly in positive territory and not a single CLO defaulted.

CLO returns were strong across the capital stack in 2020

Source: J.P. Morgan CLOIE Index, January 1, 2020–December 31, 2020.

We have a generally constructive view on credit markets for the remainder of 2021 given an improving economic backdrop, widespread vaccine distribution and supportive technicals. While credit spreads are tight, we firmly believe active managers can find opportunities for excess return this year. CLOs are one area where we continue to see positive momentum.

Key takeaways

  • CLOs performed well throughout 2020 but in our view remain attractive in 2021.
  • History tells us the spread between CLOs and comparably rated corporates may have room to tighten.
  • Beyond these relative value assumptions, experienced CLO investors may find opportunity in CLO refinancings and resets.

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

All investing is subject to risk, including the possible loss of the money you invest.

Kara O’Halloran, CFA

Director, Investment Research

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