Photographer: Dario Pignatelli/Bloomberg
This Complex Credit Market Found a Way to Keep Deals Alive ForeverBy and
Resets satisfy investor demand, avoid chase for scarce loans
CLO can be reset multiple times to cut risk and lower cost
Taking advantage of good times in global credit markets, collateralized loan obligations have evolved to make old deals new again.
Resets, which give years of new life to CLOs that are about to expire, burst forth this year to help set record activity in the CLO market, according to data compiled by Bloomberg. More than $60 billion of resets have priced in 2017, compared to about $22 billion last year, and almost nothing in years past.
"Reset technology of CLOs makes CLOs more like permanent capital vehicles. And permanent capital is the holy grail for asset managers," said Jonathan Insull, a portfolio manager at Crescent Capital, which has about $25 billion of assets under management.
CLOs, which securitize bundles of leveraged loans, are created to only exist for a specific length of time. At the end of the reinvestment period, typically four or five years from formation, asset managers sell the portfolio of leveraged loans, pay out bondholders at preset liability rates and give remaining proceeds to equity investors.
Resets extend the CLO life cycle, adjust bond yields, rejig investment parameters and often also increase the size of the vehicle. Their rise allows CLO managers to retain assets rather than constantly create replacements, while investors get to keep established portfolios.
“We really like resets. It’s up there with sliced bread,” said Tom Majewski, managing partner and founder of Eagle Point Credit Management, a CLO equity investor, who expects to see another $60 billion to $70 billion of resets in 2018. “Let’s say you’ve been in a deal for three to five years that you like because you are doing well -- with a reset, you have the opportunity to keep it going.”
Yield-hunting investors from all over the world, including Middle East sovereign wealth funds, Canadian pensions, and Chinese hedge funds, flocked to CLOs this year. New issuance is about $115 billion, just shy of the all-time record of $124 billion in 2014. When resets are added, total supply this year hit $175 billion.
The spike in demand tightened CLO bond spreads significantly, with the AAA portion dropping to as low as 90 basis points over Libor after a reset from close to 150 basis points before.
As bond investors accepted lower spreads, CLO equity investors seized the chance to support returns on old CLOs -- which have been undermined by loan spread compression -- and keep deals in place longer.
“Calling the deal doesn’t make sense. Equity can just reset the deal,” said Vincent Ingato, a senior portfolio manager at Zais Group, with $4.14 billion in assets. “You can look at a reset as almost a new CLO. But they’re a little more economic -- legal fees are a little less, and you don’t have to warehouse a deal.”
Since resets have an existing portfolio of leveraged loans, they can sidestep the fierce competition from rival CLOs managers and other institutional investors for scarce credit. They can also bypass the costly task of warehousing.
“The hardest part can be assembling the pool of loans,” said Insull. “Resets take away one of the most challenging things in this market.”
It also addresses a pet peeve that CLO investors have about managers: failing to deliver a portfolio that looks like what was pitched in the model portfolio. The risk of that is lower in a reset with an existing pool of debt.
“As an equity investor, it takes a lot of ‘start up’ risk out of CLO investing on the new-issue side,” said Majewski.
Resets, however, lack the shiny factor of a entirely new CLO, which hold the promise of a pristine portfolio with no reminders of past credit missteps. And older CLOs tend to hold shorter-dated paper that typically yield less than their longer-dated counterparts.
Not only are CLOs resetting, but they are resetting again. For instance, a 2014 CLO from Palmer Square Capital Management reset for a second time this month, after its first reset in December 2016.
The concept is not quite “perma-CLO,” says Majewski, but it does trend in that direction.
"These CLO resets could reset again if the market is open five years from now. It is completely market-driven," said Lauren Basmadjian, a portfolio manager at Octagon Credit Investors. Basmadjian oversees 11 CLOs, four separately managed accounts and three commingled funds, accounting for $7.7 billion in assets.
Just like new CLOs, CLO resets in 2018 will depend on how credit markets move. If CLO bond spreads widen, or underlying loan assets become abundant, the pace of CLO resets would slow since equity holders who make the decision might opt to liquidate, not reset.
"Resets are an easier concept in a benign credit environment; in a credit spread-widening environment, it may be more difficult to do them, and they would slow down somewhat, but they wouldn’t stop,” said Adam Hagfors, chief investment officer and managing partner at Silverpeak Credit Partners, which invests in CLO equity.
For 2018, the market looks strong for CLOs, according to Wall Street outlook prognosticators. Analysts at Wells Fargo & Co. even predict a possible record-breaking year for new CLO issuance. Meanwhile, with little on the horizon to stall the CLO machine, CLOs will reset, reset, and reset again.