S&P: Beware of Extension Risk in Older Euro CLOs
European collateralized loan obligations issued before the financial crisis are nearing the end of their reinvestment periods. Yet the maturities of their holdings continue to shift further out into the future, in part because the term of these loans are being amended and extended.
This creates potential risks for CLO investors, according to Standard & Poor’s. In a report published May 14, the rating agency said CLO noteholders may have to wait longer to get their principal back. They may also have to accept lower returns if CLO managers sell the loans in the secondary market to repay the note principal.
Investors in both the U.S. and Europe are starting to get wise to this risk, as many deals completed more recently carry conditions that have to be fulfilled before these amend-to-extend deals can push through.
S&P said that, at the end of 2012, the maturities of leveraged loans backing the CLOs it rates were concentrated in 2017 and 2018. That represents a shift from the end of 2011, when the peak years were 2015 and 2016.
For example, at the end of 2012, these CLOs were invested in €15 billion ($19.3 billion) of leveraged loans maturing in 2017. By contrast, at the end of 2011, these CLOs had only €8.9 billion of loans maturing in 2017, and at the end of 2010 this figure was just €6.5 billion.
S&P sees two factors contributing to this shift to longer-dated assets. In certain cases, the CLO manager has some ability to reinvest, even after the end of the deal’s reinvestment period. But even if the manager cannot reinvest, a CLO’s loan maturities may be shifted as the result of amendments modifying the terms of its existing holdings. These so-called amend-to-extend transactions prolong the maturity of existing loans. Often they also result in a change in the loan’s spread to be closer to current primary market levels, S&P stated.
These transactions can be viewed in a positive light, particularly if they allow borrowers to avoid default, thereby increasing the chances the CLO investor will be repaid.
“Extending what is considered to be a maturity wall has key implications for the leveraged loan market,” said Matthew Jones, an analytical manager at S&P. “The extension means leveraged companies may be able to renegotiate the terms and pricing of the existing loans and provides additional time before repayment is due.”
The increased spread that usually comes with amended loans provides a higher interest coverage for noteholders as well as presents a potential pick-up for CLO equity holders in as far as the CLO is able to distribute interest proceeds via the waterfall structure. And for CLO managers, this type of deal would mean that the CLO will be more heavily invested for longer, thus generating more fees.
But loans with extended maturities can also cause unintended consequences for CLO investors. Senior noteholders’ principal investments can potentially be repaid later than expected. These deals can also create long-dated assets that go beyond the CLO tranche’s legal final maturity date. Because such loans will not repay principal prior to when the CLO note principal is due, noteholders are probably going to experience market value risk if these loans have to be sold in the secondary market to pay back the CLO note principal.
“From a rating perspective, the way we analyze the ability of the manager to add different collateral is tied to an investment criteria that we are normally comfortable with. The types of proceeds that managers can reinvest are also strictly limited after the reinvestment period,” Emanuele Tamburrano, a director at S&P said. “However in amend-to-extend transactions, we would penalize a deal if a significant part of the pool, or a situation where, as per our published criteria, above 5% of the pool is constituted by assets which have a maturity longer than the maturity of the notes. If the maturity of the loan in question goes beyond the maturity of the note itself, this might cause market value risk and this is factored in from a rating standpoint.”
With the growth of amend-to-extend loans, investors are starting to be a little more wary. “Investors, given what they’ve seen, have become wiser to the potential risks in extending transactions,” said Sandeep Chana, an associate director at S&P. “CLO 2.0 transactions now contain restrictions that would limit the extension and potential market value risks that we’ve seen in 1.0 deals.”
The S&P report notes that these restrictions take the form of conditions that must be satisfied in order for the amend-to-extend transaction to be accepted.
For example, some deals have weighted-average-life tests. There are also requirements that the loan’s extended maturity must not be longer than the rated notes’ maturity and/or the amend-to-extend deal can be accepted if it falls within a percentage limit allowed for assets that are long-dated where these assets’ maturity dates do not exceed two years after the final maturity of the CLO’s rated note.
S&P also added that in newer deals, any upfront fees that a CLO manager might get when engaging in amend-to-extends are paid in the transaction’s interest and/or principal accounts prior to flowing through the interest or principal waterfall.
These kinds of restrictions are also found in new U.S CLOs.
Deborah Festa, a partner at law firm Milbank, Tweed, Hadley & McCloy, said that in terms of amend-to-extend transactions in the U.S., the maturity extension mechanics were fairly easy in CLO 1.0 deals compared to current 2.0 transactions.
“Now investors are more concerned about the credit risk and other risks associated with the collateral maturing after the maturity date of the notes,” Festa said. “There are now some newer deal requirements including [the requirement] that the weighted-average-life test be satisfied, that didn’t exist in older deals.”
She also said that, in earlier deals, collateral managers were able to reinvest after the end of the reinvestment period proceeds from sales of credit improved assets, which are those that the collateral manager exercises discretion to determine if they have improved in value and credit risk. These types of reinvestments are happening less frequently in more recent transactions.
In the end, what matters is the quality of the underlying credit and not a transaction’s features, including whether there’s an amend-to-extend feature.
“It’s about the ability of borrowers to repay those loans and about answering valid questions about the underlying credit risk,” she said. “Investors need to understand the CLO manager’s background and processes—how does the credit review process work, how much diligence was exercised in understanding the underlying credits, how much team expertise is there in terms of credit—and less about the mere ability to agree to a maturity extension.”