Collateralized loan obligations (CLOs) are becoming victims of their own success.
Spreads in the primary market have tightened so much over the past couple of years that holders of the most subordinated tranches of CLOs (also called the “equity”) that were issued as recently as 2011 are expected to call them this year in order to fund new deals more cheaply.
That means investors in the more senior tranches of these transactions will have to find other places to put their money to work, most likely in lower-yielding assets.
Call activity is a constant for CLOs, which have final maturities of 10 years or more but can only purchase new collateral for the first three to five years of their life span and are typically eligible to be called even earlier.
Analysts at Wells Fargo have tracked 75 CLO redemptions that occurred between the start of 2011 and February 2013, according to a report published Feb. 11. In aggregate, these redemptions amounted to $35 billion in original balance, or $16 billion in outstanding balance, at the point of redemption.
However, many of these deals were issued in 2003 and 2004 and had already exited their reinvestment periods and begun paying down senior bondholders’ principal, reducing returns to investors in the most subordinated tranches.
Going forward, much of the call activity is expected to come from more recent-vintage deals that are still able to reinvest proceeds from payoffs of the loans in their pools of collateral.
Analysts at the Royal Bank of Scotland (RBS) say that there are 34 CLOs issued in 2010, 2011 and 2012 that will be exiting their non-call periods in 2013, with the bulk, or 26, coming from the 2011 vintage.
The question is, “How long will these deals remain outstanding, given the recent tightening in CLO liability spreads?” said Richard Hill, a director of CLO and CMBS strategy at RBS.
Hill noted that triple-A bonds issued by CLOs at 155 basis points over LIBOR in 2012 can now be issued at closer to 120 basis points over LIBOR, “which potentially means a greater return to equity.”
Another reason that recent-vintage CLOs are likely to be called: they are often an easier, and less expensive, transactions than would be the case for so-called legacy transactions issued before the financial crisis.
Equity holders in CLOs issued pre-crisis generally have only the option to either call or refinance these deals. When a deal is called, the collateral manager sells the collateral at current market prices and uses proceeds to repay note holders; when a deal is refinanced, it issues a replacement class of notes and redeems the original notes. In both cases, proceeds must be sufficient to at least repay the existing notes at par.
By comparison, more recent deals provide for a third option: repricing. In this scenario, it is not necessary to repay the principal of all note holders, just the principal of the investors that do not agree to accept a reduction in the spread on their notes. This is typically much easier than acquiring a loan to redeem notes or issuing one class to retire another.
“We believe that repricing language in new issue CLOs gives equity holders a distinct advantage compared to legacy deals, especially in a spread-tightening scenario for the underlying loans,” Hill and fellow CLO analyst Kenneth Kroszner wrote in a Jan. 11 report.
Steven Oh, who heads the leveraged finance group at CLO manager PineBridge Investments, said that refinancing may be the most likely outcome for many 2011 vintage deals. “Given the scarcity of portfolio assets, it may be beneficial to move the entire portfolio into a new transaction, especially those with a tightly knit equity investor base,” Oh said.
“The current market yields can induce the existing debt lender to reinvest and do it at an attractive spread relative to alternative options.”
PineBridge has brought 16 CLOs to market, two of them in 2012. The firm has over $8 billion under management in CLOs and other forms of leveraged finance, according to information posted on its website.
Wells Fargo CLO analyst Dave Preston also sees the potential for deals priced in 2010 and 2011 to be called, refinanced or re-priced. However Preston thinks that there is a more compelling case for some managers to do this than others, given the wide disparity in triple-A spreads in these vintages. “While some are much higher than current market levels, the deals with spreads in the 120-130 basis-point range may be less likely to be called or have the senior notes refinanced,” he wrote in the Feb. 11 report.
Fitch Ratings has more precise figures; in a Jan. 31 report, the ratings agency said that 20 of the 33 CLOs that were issued in 2010 and 2011 and will exit their non-call periods this year pay their most senior liability a spread above 140 basis points, while 11 of those CLOs have senior notes that require a spread of 160 basis points or greater.
Fitch expects to see a “moderate” amount of call activity as players take advantage of the cheaper funding available on new CLOs.
Preston said that, in some cases, re-pricing mezzanine notes may not make as much sense as it does for senior notes. “Obviously, repricing mezzanine notes does not produce nearly as much equity returns as much smaller decreases in triple-A spreads,” the analyst said in the report.
Mezzanine tranches are typically much smaller than senior tranches.
Not all of the deals called this year will be recent vintages. Wells Fargo expects to see more 2003-2004 vintages called. In the past, equity holders have made efforts to extend the life of these deals, many of which have even lower spreads than new issues. But the deals have now amortized so much that this advantage has been lost over time.
Also, these older deals have weighted average life tests and maturity limitations that are more burdensome than those of newer deals. Amortization can also lead to less interest coverage on the notes, potentially even causing deals to fail their interest coverage tests, Preston said in the report.
Now that the primary CLO market is more active, and spreads on triple-A tranches are tightening, it may be more acceptable to refinance into a new CLO. “As the CLO ages and the senior notes are paid down, the cost of the debt increases,” Preston said during a phone interview. “There are also constraints with what can be purchased and with what can be kept in the trust. The CLO has limits in terms of average life of the assets and their maturity.”
Preston also expects deals issued in 2008, after the onset of the financial crisis, to be called. This vintage is comprised of less traditional structures, including restructured CLOs. Many of the deals also had less generous reinvestment provisions, with the cost of debt potentially higher compared with other vintages.
John Popp, head of the credit investments group at Credit Suisse Asset Management, said that participants are generally being economically rational and looking at the cash-on-cash distribution on pre-crisis deals, given where spreads are and the fact that liabilities are still inexpensive.
“In our own portfolio, we continue to look at it across the board in terms of what we are getting versus what pickup there is in a liquidation,” Popp said. “Some deals have amortized so much that the arbitrage gets squeezed.”
He added that, on most transactions that came to market before the financial crisis, an outright call or liquidation of a portfolio might be the more appropriate option, because the collateral in these transactions does not necessarily fit the profile of new-issue deals.
Credit Suisse Asset Management has been one of the most active CLO managers, closing six deals totaling $3 billion since the financial crisis, according to Moody’s Investors Service.
Scott D’Orsi, a partner at Feingold O’Keeffe Capital who manages the firm’s CLO business, said that it is reasonable to expect deals issued pre-crisis to be called, given the accelerated deleveraging of late, although, “We haven’t really seen many calls to this point because these legacy deals have very low cost of capital associated with them, and the quarterly payments remain attractive. What we have seen is an increase in BWIC [bids wanted in competition] activity as more investors look to exit sub notes and perhaps deploy capital in new CLO transactions, but that’s not to say that returns on equity in CLO 1.0 are no longer attractive.
“CLO 1.0 sub notes were clipping 7%, 8% or even 9% quarterly payments for an extended period, but those outsized quarterly payments may be coming to an end, given the asset spread compression, so those investors may look to exit and reinvest in 2.0 deals,” D’Orsi said.