CLOs had an awful October — what does it mean for the credit markets?
U.S. stocks are setting all-time highs, unemployment has fallen to a 50-year low, and there’s reason to believe an actual trade deal could be signed in the not-too-distant future.
Everything’s great, right?
In many ways, yes, but …
There’s a crack showing in the corporate credit markets. It’s not flashing red, but it’s worth paying attention to … because it has shades of 2008.
It’s all the more important if you’re an income investor who’s been wading into this corner of the market looking for meaningful yields.
So, in this Digest, let’s make sure you’re aware of what’s happening. That way, we can enjoy the new stock market highs of today, while preparing for the risks of tomorrow.
***The danger involves something called “collateralized loan obligations” (CLOs)
I’m going to turn to Neil, editor of Profitable Investing, to help explain a CLO. As regular Digest readers know, Neil is a master income investor, helping his subscribers find high-quality yield, whether that be from dividend stocks, bonds, REITs, MLPs, or other instruments.
From Neil:
(A CLO) is where companies obtain loans from individual or syndicated groups of banks, which are then either held or pooled and in turn sold into the market, where banks and other financial firms invest in them.
CLOs are a great means for banks to reduce credit risks in their loan portfolio while also providing investors with higher yields and companies with additional funding opportunities.
The downside is that the loans tend to be light in documentation as opposed to traditional origination of corporate bonds. The originators, eager for fee income, can push transactions that might lean on the aggressive side. And buyers of CLOs often don’t or can’t do their homework on what’s really under the hood. And since many of the underlining loans in CLOs are subordinated to corporate bonds, there is additional credit risk if and when something goes wrong.
If this rings familiar, it’s because CLOs are similar in nature to CDOs — which are “collateralized debt obligations.” You likely remember CDOs as the financial weapon of mass destruction that nearly destroyed the global economy back in 2008.
Now, CLOs aren’t fundamentally bad. The problem — similar to what happened with CDOs — is when investors don’t “do their homework” as Neil wrote, separating quality CLOs from the trash.
Back to Neil:
As long as the originators are good at credit analysis and the investors take the time to know them before they buy, it’s all good.
However, as we found out in 2007-2008, many buyers don’t do their homework. And when cracks formed in the underlying loans, black holes began to form on the balance sheets of banks and financial firms.
***What’s been happening with CLOs recently?
Well, in October, while U.S. stocks were climbing toward all-time highs, many CLOs were erasing their gains on the year.
From The Wall Street Journal:
Now some CLO bond prices are falling again. That is because the riskier loans the CLOs own are dropping in value as the companies that borrowed them start running out of cash.
CLO bonds rated double-B, which are among the riskiest CLO securities, returned about 10% this year through June. But recent declines, especially last month, erased most of the gains, giving holders a roughly 1% return this year through October.
This is problematic — especially because the size of the CLO market has more than doubled since 2010.
Thanks to an unprecedented wave of $3.5 trillion in private equity buyout deals and historically-low interest rates, investors have gambled on riskier assets, pouring money into the CLO market.
From Bloomberg:
But as odds of a recession in 2020 grow, ratings downgrades could cause a stampede of selling by CLOs, potentially cutting off scores of companies from additional credit, preventing them from refinancing their debt, and threatening their survival.
Almost 40% of issuers of junk-debt (which includes leveraged loans) are now rated B3 and lower, according to Moody’s, a record high.
Bloomberg goes on to warn that volatility in the CLO market could spill over into the high-yield bond market. That, in turn, could send ripples into the broader economy that could deepen or prolong a potential recession in 2020.
***What’s behind all of this?
In short, investors reaching for yield.
From Bloomberg:
What makes it all work is investors hungry for yield in a world where interest rates have been at historic lows for 10 years and trillions of dollars of debt with negative yields.
Now, the same low rates that have fueled the market are creating problems for it.
This is where Neil George comes in.
Yes, many investors need income from higher-yielding investments. But no, that doesn’t mean these investors need to take excessive risk, such as investing in questionable CLO investments. There are still quality, high-yielding investments, even in today’s low-rate environment.
This past September, Neil released a book that tackles this issue head-on. It’s called Income for Life: 65 Income Streams ANYONE Can Collect.
The book includes 65 different income plays. There are investment ideas, as well as unique “side hustle” opportunities.
Here’s Neil on the investment opportunities in the book:
There are many securities which I outline that offer yields that are multiples greater than that of the S&P 500 and the general US bond market — all with minimal risk from proven companies’ stocks, bonds, preferred shares ETFs, closed-end funds, and other funds.
All of these are buy-and-own — with no need to trade anything or deal with options strategies. And yes, I have plenty of yields running from 7%, 8%, 9% and over 10% — all vetted and proven in their capability to deliver income for any individual investor.
But as just mentioned, the book also includes non-market-related income ideas. Back to Neil:
And it also provides numerous means to generate additional income outside the markets. There are countless ways to generate income beyond regular paychecks. And I present a wide variety of ideas and the steps needed to make them pay and pay well — all while doing many things that folks are interested in already.
To learn more about Income for Life: 65 Income Streams ANYONE Can Collect, click here. But whether you get help from Neil or elsewhere, be careful about reaching for yield in today’s market. And be especially careful of CLOs. From Bloomberg:
The situation’s only getting worse as downgrades by S&P outpace upgrades by the most since 2009. And the ratio for Moody’s isn’t far behind. Companies rated near or in the triple-C zone have $508 billion coming due in the next five years, according to data compiled by Bloomberg …
The world’s financial watchdogs are taking notice. The Financial Stability Board, set up in the aftermath of the financial crisis, is investigating. In an October letter to G-20 central bankers and finance ministers, it singled out CLOs and leveraged loans as an area for concern.
The market’s heightened complexity and opacity, it said, make it “difficult to assess potential spillovers and risks.”
Income investors, take notice. If you need yield, let Neil help. But watch out for reaching today.
Have a good evening,
Jeff Remsburg
