Do you remember those complex derivatives commonly known as Collateralized Debt Obligations, (CDO’s) which were based on bundled worthless sub-prime mortgage paper?

In order to refresh your memory, backtrack over ten years ago and think inflated credit ratings by America’s two leading credit rating agencies, together with significant investment market abuses and practices by two of the developed world’s leading investment banks, or as they are known today – bank holding companies.

Gathering market participants with robust momentum, we have a similar type of derivative which has become an increasingly important component of institutional investors’ asset allocation strategies. They are called Collateralized Loan Obligations (CLO’s) and they demand over half of the domestic leveraged loan issuance. 

Okay, their underlying assets are far more diversified than those of their residential mortgage-backed securities CDO’s counterparts, and for that reason alone it can be argued they are safer investment vehicles when compared against the spark that ignited the 2008 / 2009 global financial crisis. However, when we dig deeper into the CLO market some alarming statistics rear their ugly heads.

For example, as at March this year outstanding CLO’s globally totaled $700 billion, with annual new issues of over $100 billion. These figures are comparable with sub-prime CDO volumes in 2008. Furthermore, the U.S. CLO market has grown in size since the 2008 / 2009 financial crisis, alarmingly by 119% between the period January 2013 to March 2019.

Moreover, this year alone, U.S. CLO issuance has been challenged as spreads on Triple A tranches, the largest and most senior piece of the funds, have continued to widen. Expanding spreads can reduce returns payable to equity holders who are the final recipients after all other debt holders who receive their distributions.

History has repeatedly shown us that financial markets have remarkably short memories, and recently they have convinced themselves that CLO’s are safer instruments than the match that lit the fuel which drove the 2008 / 2009 financial crisis.

Ticking time bombs eventually stop ticking and explode. We can only hope and pray we are not dealing with a ticking bomb.

Casdaq Trading is an International Direct Market Access Trading House offering bespoke access for retail traders and investors across the globe.

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