The main problem has been increasing nervousness about the prospect of defaults and losses on loans. It is true that defaults have picked up but these have tended to be concentrated in the oil and energy sectors – areas that most of these funds have relatively low exposure to.
I thought it might be worth having a closer look at a couple of high yielding, collateralised loan obligation (CLO) funds to see how they have been faring. CLOs are asset-backed securities, such as mortgage bonds, that are divided into tranches with the most senior getting paid their interest, or coupon, first.
Carador Income Fund (CIFU) and Blackstone/GSO Loan Fund (BGLF) are two funds that are managed/advised by two different teams working for the same firm: CIFU by GSO/Blackstone Debt Funds Management and BGLF by Blackstone/GSO Debt Funds Management Europe.
CIFU’s remit is global but the portfolio tends to be invested entirely in CLOs weighted towards the US. By contrast, at the end of March 2016, BGLF had 28% of its assets invested in loans made to US companies but the balance was invested in Europe (10% of the fund is in UK loans). So between them, the two funds cover the US and European CLO markets.
These funds invest in the ‘equity tranche’ or junior debt tranches of CLOs. This means they usually accept the first loss position in the event that a borrower struggles to repay interest or capital.
The underlying loans in these CLOs tend to be rated below investment grade. This means the CLO is investing in loans that come with higher interest rates but also have a corresponding higher potential for defaults.
It is worth remembering with all debt funds that defaults and losses are not the same thing. Even if a borrower runs into problems, the loan is often secured in some way and all or part of the amount owing can usually be recovered over time.
The nature of these funds though is that most, if not all, will experience a proportion of realised losses over the course of their lives. The important thing is that the returns the equity tranche achieves adequately compensate investors for these losses.
According to Morningstar, CIFU is currently trading on a premium of 8%, while BGLF trades at a 7.6% discount. This implies that investors are more nervous about European loans than US ones.
To me, that seems odd given that the US economy is further into its economic cycle than Europe, and US leverage ratios are higher than those in Europe. It may indicate some nervousness about the strength of the euro relative to the US dollar or it could just be that CIFU pays a higher yield than BGLF.
What it does not reflect is that BGLF has been outperforming CIFU by some considerable margin in recent months. Its NAV is up by 9.9% over the past six months against a 6.2% fall for CIFU. However, a large part of this can be explained by currency movements.
BGLF was launched in July 2014 and its NAV is still more or less the same as at launch. Putting aside an improvement in April 2016, CIFU’s NAV has been falling for some time. CIFU’s total NAV return was -9.7% in 2015, which made me wonder whether it was paying too high a dividend.
However, CIFU says that 2015 was the worst year for the US high yield and loan markets since the start of the financial crisis. The Credit Suisse High Yield index had the fourth-worst year in its 30-year history and the Credit Suisse Leveraged Loan index produced only the second negative annual return in its 24-year history. If anything, CIFU’s NAV held up relatively well as the price of equity tranches issued by CLOs created since the financial crisis fell by 34% in 2015.
CIFU is reducing this year’s distribution target to nine cents per share, which would still put it on a yield of 10.5% at the current share price. CIFU’s managers are not predicting a recession in the US but believe increased volatility is likely to persist in the debt market for a while. This and the depressed prices for CLO equity tranches present an opportunity for them to add some value.
BGLF’s managers were buying loans in February when markets were selling off and have already been rewarded because pricing has since improved. This seems to be encouraging more CLO issuance and is making financing for the senior tranches cheaper, enhancing returns for the junior and equity tranches in new CLOs. BGLF, which currently yields 8.9%, is keen to expand to take advantage of these opportunities.
I think both funds look interesting at the moment and would consider taking advantage of any further volatility in discounts.
SOURCE: theaic.co.uk
