Opportunities in alternative credit
Alternative Credit investments span the liquidity spectrum and are secured by assets that generate cash flows upon which the investment relies for repayment. From an income and yield perspective, these assets offer varying premiums relative to traditional fixed income. These investments also offer downside protection, given ample levels of credit enhancement and robust covenant packages.
The Opportunity – Relative Value
The below chart illustrates the relative value opportunity available to investors in collateralized loan obligations (“CLOs”), an Alternative Credit asset class, relative to similarly rated corporate fixed income.
Insight – CLOs Avoid Most Underlying Corporate Defaults
CLOs invest in diversified and actively managed pools of corporate loans. Year-to-date, 59 non-investment grade companies have defaulted on their loans, representing approximately $50 billion of paper. In aggregate, CLOs hold approximately 59% of all corporate loans outstanding. During periods of retail loan fund outflows, CLOs’ share of the primary issue loan market can rise to 75% or more; such has been the case during most of the last 18 months .
One might therefore expect that CLOs would have been caught holding their fair share (59% or more) of the defaulted issuers. Not so. Per Ares’ proprietary insights, we see that CLOs’ exposure to defaulted loans is 13.3%. Moreover, if we look back in time and ask, “did CLOs ever own these loans which eventually defaulted?” that exposure increases only modestly to 25%.
This repeats a pattern that we have seen in the CLO market in previous cycles: CLOs have historically had significantly less exposure to the weakest credits than other types of loan funds. At a minimum, it suggests that all the noise around CLOs and their fundamental risks is obscuring some important signals about the nature of this cycle. Why is it again the case that CLOs are underexposed to the weakest credits? The data we see on fundamental credit risks across the loan market suggests that the stronger credit performance that CLOs are experiencing is not a matter of luck but rather credit strategy and investment criteria, albeit with a range across managers.
For further insights on the most compelling opportunities in alternative credit, please visit our website, or use the contact form below.
References to “downside protection” or similar language are not guarantees against loss of investment capital or value.
Source: Ares INsight database, S&P and Ares market observations as of August 31, 2020. The 70-80% estimate is based on the exposure CLOs can have to a given new issue loan market (especially during times of retail / fund outflows, which were prevalent over the last year). Generally, CLOs comprise ~55% of the overall loan market.
Charles is a Partner, Portfolio Manager and Strategy Head for CLOs in the Ares Credit Group. Mr. Arduini serves as a Vice President and Portfolio Manager for the Ares Dynamic Credit Allocation Fund, Inc. (NYSE:ARDC). Additionally, he serves as a...