S&P Takes Dim View of Long Reinvestment Periods for CLOs

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CLOs are increasingly negotiating with investors for longer reinvestment periods.  S&P Global takes a less favorable view of the practice than the other two major rating agencies, Fitch Ratings and Moody’s Investors Service.

Most collateralized loan obligations issued since the financial crisis have the ability to actively manage their portfolios, selling existing holdings and acquiring new loans, for four years. However many CLOs issued this year have longer reinvestment periods. By S&P’s count, nearly half (45%) can actively manage their portfolios for longer than 4.5 years. A significant number can reinvest for five years. Two have six-year reinvestment periods.

CLO managers like to have the ability to keep deals outstanding for longer in order to maximize their profits.

The longer the reinvestment period, however, the more likely it is that the CLO will have to weather the next credit downturn, in which loans used as collateral could default.  To be sure, within five or six years, some of the assets in the portfolio will inevitably have paid off, eliminating the default risk. Leveraged loans have tenors of seven years, and most are refinanced or repaid within five years.  

Yet as managers put proceeds from repaid loans to work in newer loans that will likely be outstanding longer than the CLO, they increase the weighted average life of the portfolio.

“In general … we consider a longer weighted average life as an increase in stress,” S&P stated in a report published Tuesday. “Therefore, we will require the transaction to have more credit enhancement in order to assign a particular rating.”

There is a mitigating factor: the longer a CLO is outstanding, the more time there is to build up a form of investor protection known as excess spread. This is the difference between the interest earned on loans and the interest paid to CLO noteholders.  These additional funds can be used to meet any shortfalls in interest on loans that default , under certain circumstances.

Nevertheless, S&P thinks that, on balance, longer reinvestment periods result in additional risk. And while it did not rate either of the CLOs with six-year reinvestment periods, the rating agency would require additional credit enhancement, relative to a deal with a four-year reinvestment period.

It does not appear that either Fitch or Moody’s are demanding additional credit enhancement to rate CLOs with six-year reinvestment periods , however.

The $600 million Carlyle GMS CLO 2017-1, completed in March, had a six-year reinvestment period, but credit enhancement for the senior, triple-A rated notes was just 35%, according to Fitch’s presale report. That’s at the low end of the range of 34.8% to 38% for all deals completed in first quarter, which was published in a Fitch report on first-quarter CLO trends.

In fact, Carlyle’s previous deal, dubbed 2016-3, offered more credit enhancement, 35.4%, at the triple-A level, despite have a shorter reinvestment period of five years.

In Fitch’s analysis, the senior notes of 2016-3 have a break even default rate of 59.8% and an assumed recovery rate of 43.7%  

By comparison, Carlyle’s 2017-1 CLO has a break even default rate of 60.7%, and an assumed recovery rate of 43.7%.

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