About $50 billion of collateralized loan obligations may be refinanced in the next two years, rewarding holders of the most speculative portions of the funds at the expense of AAA investors, according to Royal Bank of Scotland Group Plc. (RBS)
BlackRock Inc. (BLK), Ares Management LLC and other firms have refinanced more than $2 billion of CLOs this year, and an additional $8 billion sold in 2011 will be able to cut interest payments by the end of 2013, according to RBS. Restrictions preventing more than $40 billion of 2012 investments from doing the same will be lifted in 2014, according to the bank.
Yield premiums on new-issue CLOs shrank to the lowest levels in at least three years as more investors piled into the debt seeking better returns than similarly-rated asset classes. Rising demand helped push CLO issuance to $60.6 billion globally this year, the most since 2007, according to JPMorgan Chase & Co.
“Current market spreads on CLO debt are tighter in many cases than during 2012, economically incentivizing equity holders to refinance the” debt, Ken Kroszner, a CLO analyst at RBS in Stamford, Connecticut, said in a telephone interview. “By reducing the coupon spread on the deal’s liabilities, all else equal, additional cash-flow will be generated.”
CLOs pool high-yield loans and slice them into debt securities of varying risk and return, typically from AAA ratings down to B. The lowest portion, known as the equity tranche, offers the highest potential returns and the greatest risk because investors are the first to see their interest payouts reduced when loans backing the CLO default.
Equity investors are paid after the holders of debt rated AAA down to BB or B, receive their distributions, a spread typically based off of the London interbank offered rate. By decreasing the rate paid to a fund’s bondholders, additional cash is available to equity holders.
Interest rates on the highest-rated portion of CLO debt dropped to a low this year of 110 basis points more than Libor in May from 145 basis points in January, according to data compiled by Bloomberg. While spreads widened in the last two months, they are still lower than the high of 175 basis points, or 1.75 percentage points, in 2011. Libor is the rate banks say they can borrow in dollars from each other.
CLO issuance inn the U.S. has seen a resurgence in the past four years after sales dropped to $1.22 billion in 2009 from a high of $91.1 billion in 2007, according to Morgan Stanley data. Wells Fargo & Co. says as much as $80 billion of the funds may be raised in the U.S. this year.
Investors are seeking CLOs as they offer higher interest rates than similarly-rated debt. New-issue AAA spreads were at 130 basis points on Aug. 9, compared with 103 basis points for commercial mortgage-backed securities, according to Morgan Stanley data.
A $521.5 million deal for Credit Suisse Asset Management that priced last week pays investors in the largest of three senior-rated pieces, a $190.5 million AAA portion, a coupon of 128 basis points more than Libor, according to Bloomberg data. The two other senior ranking slices pay a coupon of 130 basis points and 145 basis points.
CLO AAA spreads widened given the higher volatility and lower liquidity across markets, Rishad Ahluwalia, the head of global CLO research at JPMorgan in London, said in an e-mailed statement.
Five CLOs for more than $2 billion have been refinanced this year, including a $410 million deal from Ares and a $408.4 million pool from BlackRock, according RBS.
Lauren Post, a spokeswoman for BlackRock, declined to comment. Bill Mendel, a spokesman for Ares who works at Mendel Communications, didn’t return a telephone call or an e-mail seeking comment.
3i Debt Management US LLC teamed up with Citigroup Inc. to issue Jamestown CLO II, an approximately $508 million fund, in February, according to John Fraser, a managing partner at 3i Debt Management US. The firm is the U.S. debt investment arm of 3i Group Plc (III) in New York, which oversees $3.2 billion. The deal refinanced a 2011 WCAS Fraser Sullivan Investment Management LLC CLO.
The coupon on the highest-rated portion of the debt dropped to 127 basis points more than Libor from 165 basis points. By decreasing the interest paid to holders of top-rated slices of a CLO, the additional cash generated can be distributed to equity investors.
As most CLOs sold in 2011 have two-year, non-call periods, equity holders may now seek to take advantage of lower funding costs to refinance the deals, RBS’s Kroszner said. The majority of CLO equity investor retains the right to refinance debt pieces, he said.
The manager and equity investor look at potential returns based on where the fund is today and its ability to invest, particularly once it reaches the end of its reinvestment period, compared to the cost and structure of a new deal, Fraser said of choosing to refinance.
Refinancing may allow equity holders to boost returns by more than 2 percentage points, based on a 2012 CLO with a weighted average funding cost of about 215 basis points compared with 190 basis points currently, Kroszner said. The weighted average funding cost is the average coupon spread paid to CLO debt holders.
When AAAs were lower earlier this year, equity investors may have seen an increase in annualized distributions of four to five percentage points, according to RBS. The bank sees AAAs decreasing from the current 130 basis-point area by the end of the year and into 2014, which may increase the payout to equity investors on a refinance. AAA spreads may need to continue to tighten to spur more refinancings.
“We expect the trend of refinancings to continue,” Kroszner said. “The bulk of post-crisis CLOs don’t exit their non-call periods until after 2013 so we expect a majority of refinancings to occur next year.”
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