Wall Street Games the CLO Machine to Stay Ahead of DownturnBy
More frequent resets and refinancings boost managers’ profit
Trade-off for CLO bondholders is they get lower duration
Managers of collateralized loan obligations are taking advantage of a new tool to fine-tune deal terms to their benefit ahead of an expected turn in the credit cycle to higher rates and tighter lending.
CLOs, which securitize bundles of leveraged loans, typically last about four to five years before their managers sell the portfolio, pay the CLO bondholders and give the remaining cash to investors in the riskier equity part of the deals. That has started to change, as managers increasingly seek to tweak a CLO -- shortening maturities and lowering rates more frequently -- in a way that would game any souring business environment and consequent rise in rates.
The process is known as resetting, which shortens the CLO’s life and reprices the transaction. It has the added benefit of allowing managers to capture fee income from deals that are performing well for longer, which translates to profits for the equity holders who are last in line for payouts from the CLO. In return, CLO bondholders reduce their exposure to rising rates, which would erode the value of the bonds.
“Starting late last year, you began seeing a whole bunch of deals with shorter reinvestment periods, even from stronger CLO managers” who typically would do five-year deals, said Jason Merrill, a structured finance analyst at Penn Mutual Asset Management in Horsham, Pennsylvania.
Managers until recently were inclined to reset the deal terms less frequently, using five years as a typical reinvestment period during which the manager trades the loan assets that support the securities.
Now they’re repricing deals and changing terms more frequently to reduce the rates they pay to bond investors -- effectively the managers’ cost of funds -- before a credit contraction prompts investors to flee or seek higher compensation. Ideally, they would get in one last reprice before such a turn, enabling them to ride out the storm. They also are shortening non-call periods for the bonds.
Even with last week’s bout of macro volatility, a healthy economy could mean the cycle of easy credit runs longer than expected, maintaining strong investor demand for CLOs. Deutsche Bank raised its forecast for net issuance of deals this year to $60 billion from $40 billion following a favorable federal appeals court ruling for how CLOs can operate.
For the investors in the main debt portions of CLOs, shorter reinvestment periods have the benefit of reducing duration -- the bonds will be less price-sensitive to changes in prevailing rates.
Several reset CLOs and a handful of new-issue deals started getting done with reinvestment periods as short as three, or even two, years. Moreover, in some cases, non-call periods have been decreased from the traditional two years to as little as half a year.
Last week, Zais Group opted for a three-year reinvestment period and a short one-year non-call period for its latest new-issue CLO, which priced via Goldman Sachs. The shorter reinvestment period helped tighten spreads on the AAA-rated slice to 95 basis points over Libor, the narrowest level since the financial crisis.
“Different flavors of reinvestment periods will be seen this year: 2, 3, 4 and 5-year periods,” said Amir Vardi, managing director and structured products portfolio manager at Credit Suisse Asset Management. “There are two schools of thought: one is, the longer the reinvestment period, the better, because it will have all sorts of optionality if the market corrects. The other is that if spreads continue to compress, managers may want a shorter non-call, in order to save a significant amount with a refinancing or reset sooner rather than later.”
Of course, the shorter deals will have higher equity returns out of the gate since the financing costs will be lower, Vardi said. On the other hand, managers can only buy replacement loans at similar prices to where they are now, and therefore CLO equity investors wouldn’t be able to take advantage of the potential spread widening that typically occurs during a higher-default environment.
An Equity About-Face
This latest trend of shorter durations is a sharp turnaround from the situation less than a year ago, when CLO managers started lengthening reinvestment periods to five, or even six years, for certain deals. The idea was to provide equity holders with more flexibility, especially if the credit cycle turns sooner than expected. In theory, debt holders would get extra compensation, or wider spreads, for the longer reinvestment periods. But in practice, that didn’t always happen, as “the CLO primary market doesn’t seem to price maturities all that efficiently,” JPMorgan analysts wrote in a research report last March.
Plus, since then CLO managers had to reckon with the massive surge of repricings of the loans held in their portfolios, which forced them to start lowering the rates they pay to their bondholders.
With spreads continuing to compress and investor demand skyrocketing last year, CLO managers figured they stand to save even more money. They shortened non-call periods -- an equity-friendly move -- but also agreed to shorter reinvestment periods in order to get acceptance from the bondholders.
“What’s happening now is a bit counterintuitive to the lengthening reinvestment periods we saw a year ago,” Penn Mutual’s Merrill said. CLO managers “want to maximize optionality in this late-cycle game.”
— With assistance by Sally Bakewell, and Charles E Williams