The stock markets are too high and overdue for another crash. CD’s, money markets and bond rates are the lowest in history. Are there any good high-income investments?

We are asked all the time where investors can get 5 percent to 8 percent income like “the Good Ole’ Days.” Today, a small percentage of financial advisors offer a relatively new generation of public and private funds offering income of 4.25 percent into the 9 percent range (depending on the investment and duration).

Market interest rates are historically low, and most fixed-income portfolios are concentrated in low yield assets. This presents challenges for income investors who want better potential for increased income. As a result, more and more investors are looking to alternative assets for income.

Collateralized loan obligations (CLOs) hold diversified pools of 100 to 200-plus corporate debt. CLOs are emerging as a compelling alternative for income investors. CLOs that invest in senior secured bank loans (SSLs) have historically provided attractive current income while buffering fixed-income portfolios from market volatility and the risks associated with rising interest rates. Although SSLs are typically issued to borrowers with credit ratings below investment grade, SSLs have provided positive cash yields in all years since 1997, and only one year of negative returns in 2008. This is due to several factors including the senior position of SSLs in the capital structure, which gives them repayment priority ahead of all other debt obligations, and first liens against corporate assets. As a result, SSLs have had historically low default rates with high recovery rates.

CLOs traditionally have been available only to institutions and high-net-worth investors. However, a new generation of public fund offerings is now providing a wider range of individual investors with the opportunity to participate in CLOs. Actively managed CLOs enable investors to access the expertise of high-quality managers with expertise in analyzing the creditworthiness of borrowers, monitoring current market interest rates for non-investment-grade credit, and forecasting how a business is likely to perform during the next downturn. Due to the particular features of SSLs, including interest rates that periodically recalibrate rather than remaining fixed, CLO investors can be better-positioned for varying scenarios in which interest rates either remain stable or increase in the years to come.

The Search for Yield

Investors attach far greater importance to income-generating products today than they did five years ago. The survey results demonstrate that investors’ income expectations are not being met by the income they are achieving with traditional income investments such as Certificates of Deposit (CDs), Annuities, Bonds, Cash, Investments in real assets.

A Compelling Alternative for Income Investors Seeking Higher Yield

In today’s environment where interest rates are near historical lows but widely expected to rise, investments in CLOs provide an alternative strategy for income investors seeking higher yields than can be achieved via traditional fixed-income investments.

Traditional fixed-income securities pay investors a fixed rate of interest, which is also known as a coupon, for the duration of the investment.

CLOs performed very well during the recent financial crisis, experiencing virtually no defaults during that time. This level of performance surpasses that of investment-grade bonds.

Floating interest rates potentially provide investors with protection from interest rate and inflation risk. Because their yield rises and falls with changes in the LIBOR rate, floating-rate loans are relatively less sensitive to interest rate movements than other fixed-income investments.

CLOs holding SSLs can provide a higher return than other fixed-income investments due to their floating interest rates and the higher interest rates provided by investments in loans that are not investment grade. However, investor payouts can be reduced by operational and administrative costs, which generally constitute 0.15 percent to 0.20 percent of the assets of the CLO. Some of the best-known brand names in the United States are associated with companies that do not issue investment-grade debt. Examples of such companies include H. J. Heinz Company, Dell Computer Corporation, Burger King Corporation, and The Hertz Corporation. Only a small percentage of American companies issue debt that is classified as investment grade.

Strong Historical Performance of CLO Investments

Over the past 16 years, there have been impairments on less than 1.5 percent of CLO notes, and most were cured with no losses to note holders. This level of performance surpasses that of investment-grade bonds.

Low Historical Default Rates

Recent rates of default on senior secured bank loans tracked by the S&P/LSTA Leveraged Loan Index have been below the average historical level. The trailing 12-month default rate by principal amount on senior secured bank loans was 1.27 percent at the end of 2012, according to the S&P Capital IQ LCD.

High Historical Recovery Rates

SSLs are secured by a first lien on the borrower’s assets, and the lender has the first priority for repayment. For these reasons, SSLs generally have a higher recovery rate after default than borrowings further down the capital stack. Since 1987, the average annual recovery rate on defaulted SSLs has been 80.6 percent, as compared to 63.7 percent for senior secured bonds, 48.6 percent for senior unsecured bonds, and 28.5 percent for subordinated bonds.

SSLs are corporate loans, as opposed to loans to individual borrowers. Unlike various forms of collateralized debt obligations (CDOs) linked to residential real estate, CLOs also have no exposure to commercial or residential mortgages, sub-prime debt or consumer-based debt. In this way, CLOs are very different from the varied versions of CDOs that were prominent features of the sub-prime mortgage challenges that resulted in the financial crisis of 2007–2009.

SSLs typically are loans to large- and mid-size businesses that are secured by a first lien on the cash flow and assets of the corporation. Senior secured bank loans held by CLOs have unique features that potentially benefit investors, including:

• senior priority in repayment;
• floating interest rates based on a reference rate such as LIBOR;
• security provided by a first lien on the borrower’s collateral;
• minimal correlation with other fixed-income asset classes, negative correlation with U.S. Treasury notes, and low correlation with equity and real estate asset classes; and
• lower rates of default and higher recovery rates after default than unsecured corporate bonds.

For the reasons outlined above, the historical long-term profile of the senior secured loan market suggests stability of income, low correlation with other fixed-income sectors, and solid performance in a rising-rate environment. Investors who are willing to look beyond traditional fixed-income investments are likely to find that CLOs offer a compelling value proposition that addresses the significant gap in expectations between what they want from their income investments and what they actually receive.

CLO investments involve a high degree of risk and may be considered speculative. They have limitations on liquidity and significant operational and administrative costs. Distributions and Quarterly tender offers not guaranteed. Investors are advised to consider the investment objectives, risks, and charges and expenses which are detailed in the prospectus. Please read it carefully before investing. Past performance is not necessarily indicative of future results.

Scott L. Olson is president of Atlantic Financial Advisors, LLC, and is a Registered Investment Advisor. With 36 years’ experience in Financial and Estate-Planning, Wealth Preservation and Wealth Transfer, Scott has been a popular speaker across the U.S. to groups of Attorneys, CPAs, Financial and Estate Planning professionals. He provides Continuing Education courses to Attorneys, and CPAs. Scott’s expertise includes, not just Roth-Conversion, but tax-free, or “Substantially Discounted Roth-Conversion©” and the Annuity Arbitrage, a tax-favored income and estate-tax free wealth transfer technique. He can be reached at scott@atlanticfinancialadvisors.com

Securities offered through Financial West Group (FWG). Member FINRA/SIPC. Atlantic Financial Advisors, LLC, Registered Investment Advisor not FWG affiliated. For educational purposes only and NOT an offer to sell any security. This information is based on sources we believe reliable but is not considered all-inclusive.

Photo. Headshot of Olson on file