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Push for higher CLO equity returns could cost mezzanine investors

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Strong demand for leveraged loans is putting the squeeze on holders of the riskiest slices of collateralized loan obligations, known as the “equity.” CLO managers, who are often equity holders themselves, are trying to boost returns, but some of the measures they are taking could hurt other CLO investors, according to Morningstar Credit Ratings.

Loans in CLO portfolios are constantly being refinanced as borrowers take advantage of strong demand for floating-rate debt. With less interest coming in, there is less left over for equity holders after paying out interest and principal to holders of more senior CLO securities.

The primary way that CLO managers address this is by refinancing their own deals, forcing holders of CLO securities themselves to accept lower returns. However, some managers have been taking the additional steps to boost equity returns, and some of them could take a bite out of investors in other CLO securities.

Morningstar is particularly concerned with two strategies. The first is something that some managers can take advantage of at any time: flexibility in the way that they calculate excess par, which is typically defined as the par, or face, value of all assets in the portfolio minus the target par balance. There are a number of ways a manager can generate excess-par, and some actually improve the quality of assets in the pool, while others do not.

One method Morningstar does not view favorably is selling higher-quality loans and using the proceeds to buy loans trading below face value, presumably because they are considered to be poor credits. Managers can then hold the riskier loans on their books at face value.

“Morningstar views this method of par building as a credit-negative development because it allows managers to increase par value at the expense of asset quality, while not necessarily increasing overcollateralization or improving the collateral quality of the pool as a whole,” the report states

The second strategy Morningstar is concerned about is only available to managers when they refinance CLOs. At this point, managers may be able to recharacterizing the excess par generated from selling loans at a profit as interest proceeds. Since principal proceeds cannot be paid out to equity holders during the reinvestment period, this pushes risk from the equity to the mezzanine tranches by way of eroding the overcollateralization cushion supporting those mezzanine tranches, according to Morningstar analyst John Nagykery.

“You’re essentially allowing an equity holder to get a payment that they otherwise wouldn’t get for a couple of more years,” he said in an interview. “We just want to make sure this flexibility is not going to create problems down the road, especially as we’ve been on the upswing of a credit cycle.”

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