A high-stakes trade in the riskiest corner of a $1.3 trillion credit market is luring some of the world's most conservative investors, raising concerns that in their aggressive hunt for higher yields they could cut some trap.

Pension plans and insurers have piled into funds that invest in equity tranches of collateralized debt obligations in recent months, according to several asset managers who spoke on condition of anonymity. The inflows have helped a host of hedge funds and other money managers, including GoldenTree Asset Management, Sculptor Capital Management, Carlyle Group Inc. and CVC Credit Partners, to raise at least $3.1 billion in less than a year for strategies dedicated only to these investments.

CLO equity — a small part of the resurgent market for CLOs that bundle leveraged loans into bonds with different security ratings — is actually a form of deeply subordinated debt. It is very risky because it is the last in line to receive payments and the first to take any losses. However, it has an appeal because of its greater claim to earnings depending on the strength of the underlying collateral. It promises returns as high as the mid- and high-teens.

While investors have typically included other hedge funds, family offices and sovereign wealth funds, the prospect of higher yields is now luring more money that has traditionally been risk-averse. The recent surge in demand from pension funds adds a potentially large buyer to the mix, and these pools of CLO capital, which were previously harder to raise because of the inherent risks, are getting bigger.

Those who raise equity CLO funds say the risks are well-understood, but some investors worry that the pensions that accumulate in these investments may take on too much risk for returns that have not always met expectations.

New York-based Dan Zwirn, founder and CEO of Arena Investors LP, an institutional manager overseeing more than $3.5 billion in assets, said the appeal of low default rates on leveraged loans, estimated at 1.5% -2% from Bloomberg Intelligence. it can mask the asset class's broader flaws.

There is this “fake notion that because default rates are low, everything is OK,” Zwirn said. “But it's not about defaults, it's about recoveries and actual losses and that's what people are missing.”

Zwirn said default rates are low because creditor protections have deteriorated over the years, making it harder for borrowers to breach debt terms and trigger a default. Recoveries for high-yield bonds and loans on a trailing-twelve-month basis have fallen to 33.1% and 41.7%, respectively, from their 25-year annual averages of 40% and 63.5%, according to JPMorgan Chase & Co.

“There's a lot of stretching and claims and 'liability management exercises,' which means the pain is going away and recovery rates are going to be much lower than expected,” Zwirn said. For returns in the low teens, equity CLOs actually have a terrible risk reward, he added.

The revival of the CLO

The CLO market is coming back to life after being weakened for much of the past two years due to a weak economic environment. Sales of new CLOs in the US are up 64% this year from the same period in 2023, according to data compiled by Bloomberg News.

Pension inflows into equity CLOs, for which there are no public valuations due to the opaque nature of the strategy, are not entirely new. The Canada Pension Plan Investment Board was present until now BACK as 2018. However, there has recently been growing interest from others as well, according to Loic Prevot, who manages CLOs as head of European leveraged loans at Polus Capital Management.

GoldenTree, which beat its goal of raising $1.3 billion to invest in first-loss equity tranches of CLOs, received mixed inquiries from some investors and won support from existing and new investors, including pensions , according to a person with knowledge of the matter. . The strategy “optimizes returns in both volatile and benign environments,” Chief Executive Kathy Sutherland said. Sculptor, Carlyle, CVC and CPPIB did not respond to requests seeking comment.

Alternative investment platform Sagard and CLO manager Irradiant Partners LP have also raised CLO equity funds in the past year, Bloomberg News has. previously reported.

So-called total arbitrage, a key metric that is an indicator of net income for CLO equity, has shown a premium of more than 200 basis points over the past six months. If that holds, more funds will continue to pursue the strategy, according to Mahesh Bhimalingam, head of European credit strategy at Bloomberg Intelligence.

European regulations

There has been a historical aversion to equity CLOs due to negative sentiment toward securitized products after the global financial crisis, but the asset class has performed well over the years, including during periods of heightened volatility, Polus Capital's Prevot said. New entrants have an understanding of the risk profile and how it fits into their investment strategies, he said.

In Europe, insurers and pension funds are limited by regulations on how much they can allocate to these higher-risk strategies. As a result, their direct participation has historically been quite low, according to Dan Robinson, head of alternative credit for Europe, the Middle East and Africa at Deutsche Bank AG's asset management arm DWS Group.

They “can't be casual about investing in CLO equity,” Robinson said. “For example, there can be deep pullbacks and market liquidity has been volatile for first-loss tranches.”

Pension funds seeking stronger returns place bets not only on broader market changes, but also on the manager who can best pick the individual loans that stack up.

Some money managers have exceeded expectations, helping to drive such interest in the product. For example, CVC's €400 million ($431 million) European leveraged loan fund launched last year achieved a Internal rate of return 47%..

But that doesn't mean all funds will be able to mitigate potential losses in loan portfolios to deliver attractive CLO capital returns.

Craig Bergstrom, chief investment officer at New York-based Corbin Capital Partners, which invests in credit funds, says these strategies have returned only about mid, or sometimes high, single-digit annual returns over the past eight years across the industry, between short periods. of high market volatility. The business will most likely come under pressure if investors are not eventually paid for the risks, he added.

Many great owners will wake up one day and ask “Wait! We took 10 times the risk of first loss in an OK credit environment and made 6% or 8% returns?” Bergstrom said.