Collateralized loan obligations are in such high demand that investors are increasingly willing to allow managers to actively manage portfolios for longer periods.
CLO managers like to preserve the option to buy and sell assets for as long as possible in order to maximize the difference between the interest earned on the portfolio and what they pay to noteholders.
In recent months, however, managers have had a particularly strong incentive to extend reinvestment periods because below-investment grade companies have been refinancing their loans at a furious pace. This results in lower interest payments on their holdings.
At the same time, the supply of new CLOs is so scarce that investors have been willing to make all kinds of concessions, in addition to prices and interest rates, to put their money to work.
But a $611 million deal sold by Carlyle CLO Management last week reached a milestone not seen in over a decade: a six-year reinvestment period. Carlyle US CLO 2017-1, the manager’s first deal of the year and 24th overall, can acquire new assets at its discretion (and under certain criteria) until April 2023.
“Over the last year and a half to two years, there have been more and more deals moving to five-year reinvestment periods,” said Derek Miller, a managing director at Fitch Ratings. But he said the Carlyle deal “is the first [CLO] 2.0 we’ve rated with that long of a reinvestment period” in the post-crisis era.
Of 36 CLOs that Fitch rated in 2016, 13 came with reinvestment periods ranging from four years and two months up to five years. Miller believes that about half the transactions rated by Fitch since the fourth quarter have reinvestment periods exceeding four years.
Recent deals that have come close include GSO Blackstone’s $611.4 million Grippen Park CLO (5.1 years), which priced in February; and MJX Asset Management’s $527.63 million Venture XXVI (5 years), which priced in January.
Before the financial crisis, reinvestment periods of six or seven years were common. When issuance resumed in 2010 and 2011, investors were generally unwilling to give managers discretion for more than three years. Then, as issuance picked up for real, in mid-2012, the standard reinvestment period moved to four years, according to research published last week by Deutsche Bank.
In 2014 there were a few deals that included a five-year reinvestment period but it only became relatively common in 2015.
Carlyle’s recent deal did not break any new ground in terms of pricing. The largest senior, AAA rated tranche pays interest at a spread of 130 basis points over three-month Libor. By comparison, there were other deals in February and March have priced at tighter margins, as tight as 122 basis points over Libor.
However, investors in Carlyle’s CLO are conceding the longer reinvestment period without gaining any additional time in which they can be assured that the deal will not be “called,” or repaid early. It has what is now a standard, two-year non-call period.
This reflects another shift from many 2015-vintage deals, in which investors received equivalently longer non-call periods after agreeing to longer reinvestment periods, according to Deutsche's research. As a result, the period from the end of the non-call period to the end of the reinvestment period held steady at around two years.
The “optionality” period is of great importance to holders of the most subordinate securities issued by CLOs, known as the “equity” (often the managers themselves), according to Deutsche. Equity holders are entitled to whatever is left over after interest earned on CLO assets is used to pay the interest and principal of more senior noteholders.
Having the ability to call a deal and prepay noteholders (after the non-call period) gives equity holders the leverage to reprice deals, negotiating to pay noteholders less interest in exchange for leaving the deal outstanding.
For example, during a loan refinancing wave in 2011, CLO managers with longer reinvestment periods were able to boost their internal rate of returns above that of managers with shorter reinvestment windows, who were unable to reinvest when loans in their portfolios paid off early.
By the same token, a long reinvestment period gives CLO managers/equity holders more flexibility to take advantage of any widening in loan spreads, since they have more time in which to trade or sell positions.
“And if the non-call period is short enough, this comes without the loss of flexibility to repay liabilities if loan spreads [subsequently] tighten,” the report states.
Longer reinvestment periods also benefit CLO investors, to the extent that they result in CLOs remaining outstanding for longer, according to Thomas Majewski, managing partner and founder of Eagle Point Capital Management, a firm that invests in both CLO debt and equity,
He noted that senior tranches of CLOs offer attractive returns, compared with other kinds of investment-grade debt. But soaring loan prices (nearly 74% of loans are trading above par on JPMorgan’s leveraged loan index, a three-year high) are prompting managers to call deals early to lock in gains.
By agreeing to longer reinvestment periods, investors are betting today’s tightening spreads on CLO triple-A’s would make it more likely that deal terms remain in place for much of the reinvestment period.
“In light of the rapid pace of CLO calls and refinancings, many debt investors are keen to find ways to have longer CLO paper in their portfolio,” said Majewski, who is also a partner for CLO management firm Marble Point Credit Management, which in January completed the acquisition of American Capital CLO Management (ACCLOM).