Our portfolio managers, Ron Zeltzer and Simon Gold, discuss the differences between CLOs and CDOs as well as their “secret ingredient”: 

The global Collateralized Loan Obligations (CLO) market reached $1 trillion in size last year. The attractive risk-adjusted returns and floating rate coupons with an inherent Euribor floor pulled both new and veteran investors to the asset class. However, the investors’ base is still limited to a tight and sophisticated community of investors.
 

CLOs still suffer from affiliation to CDOs that are considered to have triggered the 2008 financial crisis. The high entry barriers in the form of expensive systems to analyse the product’s cash flows and underlying risk make it even harder for a typical investor to invest directly in the product.  

Much has been written on the differences between CDOs and CLOs. Many CDOs had poor collateral and structure. Take a pile of the riskiest assets off a bank’s balance sheet in the form of sub-prime mortgages, add conflict of interest of the originator, mix it with exotic swaps, leverage and loose documentation and the recipe was a disaster.

None of these can be found in CLOs. In fact, CLOs have shown a resilient track record since the early 2000s with mild modifications and adjustments to the structure as part of investors’ evolving needs, such as the inclusion of ESG criteria. The collateral in a CLO is a reflection of the HY universe in the form of senior loans that are rated single-B and double-B. A typical CLO has over 100 loans issued by companies such as Altice, Netflix, Breitling and Dorna Sports.

The CLO finances the collateral purchase by issuing liabilities (rated tranches) and a residual class (equity tranche). Each tranche has a different level of subordination and priority in the cash flow waterfall, offering a different risk-return profile. The coupons in new issue currently range from Euribor + [1.2%] on the AAA to Euribor + [9.6%] on the single-B, as of the time of writing. Euribor is floored at zero. Equity receives the residual cash flow, targeting mid-low teen IRR in base case scenarios. These liabilities and equity tranches are the investment universe of Ardesia’s CLO Opportunity fund. 

Ardesia’s seeks to create attractive risk-adjusted returns by investing in different classes of CLOs, optimizing risk and return in the context of market conditions and macroeconomic risk factors. The fund is managed by veteran CLO traders and is currently invested in 50% equity tranches and 50% mezzanine tranches, varying from BBB down to B. Its uniqueness lies in the flexible mandate to invest across the capital of the CLO. The fund managers proved their ability to shift the risk-return profile as the market environment changed. During the early days of COVID the fund turned over its portfolio over 200% as the relative value of the different CLO tranches changed. The fund was awarded by GlobalCapital and SharingAlpha and was shortlisted in CreditFlux, as it delivered over 40% in the past two years. 

Read the full article at RankiaPro.