Asia’s yield-hungry investors have a lot riding on the financial engineers of Wall Street.
Faced with near record-low interest rates at home, money managers in Korea, Japan and China have been piling into complex and increasingly risky structured loan products in America. Their investments in collateralized loan obligations — including the high-yield “equity’’ tranches most exposed to defaults — have helped drive a doubling of issuance in 2017.
The bets have performed well so far. But some observers worry that Asian buyers are overlooking risks. Headwinds in the retail and energy sectors have raised the specter of defaults, while Moody’s Investors Service has stopped evaluating one type of CLO product amid concern that buyers will end up holding less creditworthy positions than they anticipated.
“CLOs are a difficult investment universe, and CLO equity is a boom-and-bust product,’’ said Mike Terwilliger, a New York-based portfolio manager at Resource America Inc., which oversees more than $9 billion and invests in CLOs. “Investors need to make sure they’re being adequately compensated.’’
Non-U.S. money managers’ share of American CLO tranches with single-A credit ratings more than tripled to 21 percent last year, mostly due to surging demand from Asia, according to Citigroup Inc.
Read more: A first-quarter roundup of CLO issuance
Korea Post, which manages about $102 billion of savings and insurance products, said in March it had been adding to CLO holdings. Japan Post Bank Co. has made plans to boost exposure to the safest tranches, people familiar with the matter said in January. Gopher Asset Management, a Chinese investment firm that oversees $17.5 billion, is currently raising money for a second global credit fund that may invest in CLOs, said Chief Investment Officer PV Wang.
Some “super-aggressive’’ Korean funds are buying equity tranches, according to Eugene Chun, who helps manage about $100 million of CLOs as a Seoul-based executive managing director at HDC Asset Management. Others are purchasing what’s known as combination notes, Chun said. The products blend investment grade and equity tranches to deliver higher yields while still maintaining adequate credit ratings.
Such heightened risk appetite marks a big shift for Asian money managers, according to Mark Okada, chief investment officer of Dallas-based Highland Capital Management. He visited the region to gauge investor interest in CLOs late last month.
“It was an audience that typically only considered the highest-quality AAA paper, but it’s waking up to the CLO opportunities beyond that,’’ said Okada, who slept an average four hours a night as he crisscrossed Singapore and Seoul to meet with market participants. Okada, who plans to visit Japan later this year, helped establish the CLO market in the 1990s and now helps oversee about $15 billion.
The additional source of inflows could hardly have come at a better time for U.S. CLO managers. Issuance in recent months has been complicated by new “risk retention” rules, which were designed to improve underwriting standards but have also made selling some structured products slower and more expensive. The regulations force CLO arrangers to hold on to at least 5 percent of each product.
Helped by strong Asian demand, CLO issuance has totaled about $32 billion so far this year, up 97 percent from the same period in 2016, according to data compiled by Bloomberg. Eagle Point Credit Management, a Greenwich, Connecticut-based investor in CLOs, predicts sales will swell to as much as $100 billion by year-end.
In many ways, it’s easy to see why Asian investors are jumping in. AAA rated CLO tranches offer yields of around 3 percent, according to Laila Kollmorgen, a Los Angeles-based leveraged loans portfolio manager at Pinebridge Investments. That compares with about 2.2 percent for 10-year government bonds in Korea and zero percent in Japan. Investors with higher risk tolerance can earn around 5.6 percent on BBB rated securities and about 10 percent for B rated tranches, Kollmorgen said.
U.S. junk bonds have yielded 4.1 percent this year, according to the Bloomberg Barclays U.S. Corporate High Yield Index.
Crucially, CLOs offer protection against tighter U.S. monetary policy. Because their underlying loans have floating rates, cash flows from the securities increase as borrowing costs rise. For foreign investors, the dollar-denominated products are also good hedges against a stronger American currency.
Unlike their mortgage-backed cousins, CLOs held up well during the global financial crisis, notes Jeff Herlyn, a principal at Tetragon Financial Management. Among 1,392 CLOs rated by S&P Global Ratings since 1994, only 35 tranches across 20 deals have defaulted.
“Investors are getting involved in the riskier parts of the capital structure given the historically strong track record,’’ said Herlyn, a CLO market pioneer at Tetragon, which has more than $19.5 billion under management and offices in New York and London.
B rated CLO tranches returned almost 15 percent so far this year, according to a May 5 report from Morgan Stanley, outperforming high-yield bonds, commercial mortgage-backed securities and 16 other categories of credit investments tracked by the New York-based bank.
Still, there are reasons to be cautious. Fitch Ratings increased its 2017 default forecast for leveraged loans — which CLOs bundle and slice into securities of varying risk and return — to 2.5 percent from 2 percent this month, citing challenges in the energy and retailing industries. The two sectors were the largest contributors of loans labeled as distressed in CLOs issued after the global financial crisis, Morgan Stanley analysts wrote in a March note.
Heightened demand for leveraged loans has driven down spreads, resulting in lower payouts for investors in CLO equity tranches, according to Floyd Tyler, president and chief investment officer at Memphis-based Preserver Partners LLC.
“U.S. CLO equity is starting to look a little less attractive,” Tyler said. “Investors may want to lighten up on this space before there’s a turn in the credit cycle given the illiquid nature of CLO structures.”
The combination notes favored by some Asian investors have also come under scrutiny because of risks associated with CLO refinancing. In some scenarios, the notes’ owners could be left with a less creditworthy product than they started with, according to Moody’s. Potential misunderstandings over the values being rated for such notes prompted the company to stop assessing new issuance late last year.
For some, the labyrinthine structure of such investments begs the question of whether investors truly understand what they’re buying.
“These are complex products,’’ said Resource America’s Terwilliger. “You are making something already complex even more complicated.’’
— With assistance by Sally Bakewell, Denise Wee, Judy Chen, and Jung Park