Fewer managers are choosing the middle ground when it comes to planning the length of reinvestment windows on reset CLOs, according to Fitch Ratings.
The ratings agency reported last week that managers resetting interest rates on collateralized loan obligations this year have either kept reinvestment periods to under two years – or have stretched the horizon for actively managing a reset CLO to five years and beyond. In some cases, the same management firm is using different strategies on different deals that it manages.
Fitch thinks that the differing reinvestment strategies reflects uncertainty about the outlook for the below investment grade corporate loans that serve as collateral, and about the timing of an expected turn in the credit cycle.
“The gap between long and short reinvestment periods [for U.S. CLO resets] has widened in 2018, as managers contend with different market signals, including height-of-market pricing and documentation terms in the underlying U.S. leveraged loans and rising interest rates,” the report stated.
The reinvestment period of an actively managed CLO has typically been four years in the post-crisis era. These periods are often considered a proxy for how long a deal will remain outstanding before managers call the notes and unwind the portfolio, selling off the underlying loans to pay off noteholders and absorb equity proceeds (if any).
Last year, a surge in resets extended the life of $62 billion in CLO deals, giving managers another three- to five-year run on performing deals. Analysts have projected a similar level of activity this year (28 resets totaling $13.9 billion have been recorded through the end of February, according to Thomson Reuters LPC), but the variance in deal extension periods have been more pronounced during the first quarter.
The average reinvestment period this year is between four and five years, according to Fitch, but “[d]eals coming to market with longer reinvestment horizons are gravitating toward five-year reinvestment periods, while those electing less than a four year reinvestment horizons are shortening the term to less than two years.”
Longer reinvestment periods allow managers to lock in historically low spreads and retain performing loans which have likely been refinanced and extended themselves during that market’s $610 million refi wave in 2017.
But the shorter periods have become more common, with some choosing reinvestment periods as short as one year for both reset and new-issue CLOs. This short duration allows managers to lower credit-enhancement levels, weighted average life stress levels and reprice the notes at lower coupons because of the reduced risk horizon (with three resets with reinvestment windows under two years reduced to an average AAA spread of 85.7 basis points). They are also positioned for another near-term reset ahead of a downturn in the credit cycle.
Investors favor the abbreviated period since they’ll receive principal repayments earlier.
Nearly half (14) of the 31 CLO managers who have reset more than one deal this year have varied their reinvestment periods by more than a year in those transactions, with the gap ranging from one to six years on in-house CLO comparisons, Fitch stated. Anchorage Capital, for example, has reset CLOs with two, four- and five-year reinvestment periods, according to Fitch.
KKR Credit Advisors, Neuberger Berman and PGIM have each reset CLOs this year with both five-year and two-year reinvestment periods.