Europe's CLO Repricing Wave Won't Stop Squeeze on Equity Holders

  • Surge in senior credit demand depresses collateral pool return
  • Managers refinance about 10.7 billion euros so far this year

Equity holders of Europe’s collateralized-loan obligations, who receive payouts after all the debt tranches, are bracing for a reduced share in the coming months as this year’s barrage of refinancings won’t make up for the drop in returns.

As income from assets in the collateral pool shrinks, managers have rushed to cut funding costs by refinancing about 10.7 billion euros on 30 CLOs so far this year, compared with 13 last year.

This has helped save an average of about 36.5 basis points across the debt tranches on CLOs refinanced in 2017 and approximately 31.5 basis points for CLO resets, according to data compiled by Bloomberg.

For AAA tranches that top the pecking order, the average spread reduction this year was 41.3 basis points, and for AAA resets it is 39.1 basis points. AAA liability spreads have tumbled all the way to 85 basis points from about 140 basis points a year ago.

In spite of these efforts, equity holders will still be vulnerable to reduced distributions as the drop in pricing amid a surge in demand for leveraged loans has outpaced the saving achieved through CLO refinancing.

But the brunt of the pain may be felt by 2016-vintage equity holders given these are still locked up and managers will only be able to refinance these transactions as they exit their non-call periods next year.

The lag effect for changes in loan and CLO liabilities to reflect in distributions means the full impact of the large step down in loan pricing, which has dropped about 130 basis points over the past year, may not become apparent until the third quarter.

“Loan spread tightening is undeniably a major driver for returns. I would be shocked if first quarter returns were not impacted,” said Hiram Hamilton, global head of structured credit at Alcentra Limited. “It may just be there is some delay for what is coming, which is lower returns for CLO equity.”

Anecdotal evidence as well as sell-side research so far suggests distributions to equity holders in the first quarter were mixed.

Silver Lining

Already some of the more opportunistic money appears to have pulled back from the market, with the bid from relative value hedge funds from the U.S. said to have faded.

But some dedicated equity investors may be taking a longer-term view. They highlight that CLO equity performance is not just about the arbitrage between the assets and liabilities and note that the benign credit environment in Europe is also supportive for the asset class’ performance.

Managers can create pockets of value by trading between primary and secondary, while fee-sharing, increasing leverage via the inclusion of a single-B tranche, par flushes, and/or reducing the discount paid on the refinanced notes can also improve the equity payout.

“The beta may be less attractive than a year ago, but managers can use alpha to generate returns as well,” said Thomas Kyriakoudis, CIO at Permira Debt Managers Ltd.

Having locked into the tight liabilities, investors will now be hoping that loan pricing has not only bottomed out, but that it will widen in the coming years to the benefit of the equity return.

And there’s even hope for some of the 2016 vintage if managers can lower funding costs and reset the reinvestment period to maximize the return potential. Many of the early 2016 vintage CLOs benefited from strong portfolios with managers able to take advantage of depressed loan prices to pick up assets cheaply.

— With assistance by Darya Robson

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