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The question is not whether CLOs are too dangerous, but what more they could and should be doing

By Welshcake

Thursday, November 07, 2019

When not digging deep to conceive vital solutions for the credit market, Welshcake likes to relax by scrutinising some of the more offbeat theories from science and history. Do germs come from space? Are humans descended from a tribe of semi-aquatic pig-chimps? Will kicking a rugby ball high into the air at any opportunity ever win you a World Cup semi-final against South Africa?

The past month was no different, although it threw up one of the weirdest theories yet to demand mental engagement: are CLOs more baneful to life on earth than climate change? It’s unusual to find myself in the camp of established opinion (let’s hope it’s just a blip) but I know where I stand on this. And it’s comforting to think that, when the world is finally on fire, we will pat ourselves on the back for averting the catastrophe of CLOs breaching their triple C buckets.

The obligatory Welsh reference

There is of course a Welsh flavour to the questions I posed at the outset. Astrophysicists Fred Hoyle and Chandra Wickramasinghe found the chance to test their epidemiological hypothesis following the outbreak of flu at Welsh boarding schools in 1978. Aquatic apes came to prominence thanks to the championing of Welsh scriptwriter Elaine Morgan, who also penned a best-selling feminist rewrite of human evolution and history called ‘The Descent of Woman’.

Unfortunately, in male hominids the external, distended nature of the old sailor’s bullion bag kind of flies in the face of a sea-dwelling past. On the other hand, lower than average male potency tallies with that of other hybrid species, although tight pants could also be to blame. And, as we know, rugby is a game played by teams of 15 men with oddly shaped balls.

In any case, these examples of Welsh efflorescence provide ample inspiration for this countryman to push his scientific theory of CLOs. The salient question for the product is not whether CLOs are too big and dangerous a part of the credit market, but rather, what more should they be doing?

As E, S and G become the other three letters on everybody’s lips, it’s natural such criteria have become wrapped up in the direction of travel for CLOs. And it’s something of an irony, in the context of recent Chicken Littling about the product, that the foremost focus of ESG market clamour is climate change.

CLOs will surely play a big part in this drive for improved standards. And if, as a recent Moody’s note suggests, European central banks start integrating ESG into their debt buying process, the wheels could start to turn quickly.

Whether this portends a meaningful advance will be determined by what approach CLO managers take. Recent deals in Europe already apply a negative screening process that discounts problematic companies and declining industries, regardless of any aspirations for the ESG stamp. A much bigger shift will come should they start to positively screen and push more impact-oriented investments.

I’m not giving up my cynical edge here. Being a buzzword isn’t enough. The market’s measures of what is ethical are very nascent — if not downright tokenistic — and it has a long way to go to iron out inconsistencies. Neither is adherence going to save the reputation of poorly performing managers. But there’s a far greater chance CLOs will play a positive role in averting climate disaster than that they will cause the next financial crisis.

CLOs are a force for good in finance

This is because CLOs are a force for market stabilisation rather than a ticking timebomb — even if their ability to stave off a rising tide of truly awful paper is limited. One way they could be even more effective is if US CLOs regained the ability to hold bonds as well as loans — a convenience lost to us in 2013 by the Volcker rule. The declining basis between CBO and CLO spreads — as noted elsewhere in this month’s Creditflux (see here) — illustrates that the time is ripe for a rethink in this area.

Let’s explode the crackpot theories and embrace hybridity. The financial world needs greater participation from an empowered CLO buyer base. Those that say otherwise can get back in the sea.

welshcake@acuris.com

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TAGS: Europe High yield bonds CLO Leveraged loans Primary market North America ESG Welshcake