In July 2014, Neuberger Berman rolled the dice, offering senior noteholders in one of its collateralized loan obligations a below-market interest rate for an initial 18 months.
The risk?
If the CLO manager could not refinance the notes at the end of that period, the interest on the $183 million tranche of the deal, Neuberger Berman CLO XII, would step up, from 115 basis points over Libor initially to Libor plus 190 basis points.
CLOs issue notes with varying seniority, using the funds received from investors to acquire pools of below-investment grade corporate loans. The most junior noteholders, known as the equity, are paid last, with whatever interest is left after distributions to senior noteholders. So cutting the interest rate on the senior, triple-A tranche increases the payout to equity holders, who are often the CLO managers themselves.
In the case of Neuberger Berman CLO XII, the initial spread on the step up notes issued in 2014 was 10 basis points less than a companion tranche of triple-A notes with a longer term.
By the same token, equity holders would receive a smaller payout should the interest rates on the triple-A notes step up.
So-called step up tranches were one of the strategies that CLO managers adopted to attract new investors after issuance dropped in 2013. Regulatory changes made CLO securities less attractive for banks, traditionally big buyers of the senior tranches. The short initial terms appealed to investors who wanted a relatively high return without locking their money up for too long.
In Neuberger Berman’s case, the strategy paid off. The CLO manager refinanced the notes this month, replacing them with notes that pay a spread of Libor plus 130 basis points – higher than the original 115 basis points, but well below the 190-basis point step up.
“It appears that both AAA buyers and equity achieved their objectives,” said Tom Majewski, president and CEO of CLO management firm Eagle Point Capital Management, which itself has a CLO step-up note tranche that it is eyeing for a refinancing in 2017.
It doesn’t always work out this way.
Last year, KKR increased the rate it paid on a step up tranche of notes of its KKR 2013-2 CLO to Libor plus 175 basis points because prevailing market rates were no lower, making it uneconomical to refinance the tranche. So while the manager paid less during the initial period than it did on a companion tranche of the deal, it ended up paying a premium to the companion tranche when this period ended.
Investors in the step up tranche were finally able to cash out last week, when KKR refinanced in order to avoid another step up, to Libor plus 200 basis points. The new notes pay Libor plus 145 basis points. Two other small, fixed-rate tranches of the deal that did not step up were also refinanced in order to take advantage of lower prevailing interest rates, according to research published this month by Deutsche Bank.
Likewise, American Capital increased the rate on a $140 million step up tranche of ACAS CLO 2013-2, to 160 basis points from 110 basis points, in April 2015. But investors were able to cash out recently before the interest on the tranche stepped up again. The new notes pay Libor plus 145 basis points.
And Carlyle Group recently refinanced the $155 million tranche of Carlyle Global Market Strategies CLO 2014-3 that was set to step up from Libor plus 133.5 basis points to Libor plus 175 basis points; the new notes pay Libor plus 145 basis points.
So far this year, four CLOs with step up tranches have refinanced to avoid paying a higher coupon, among a total of six CLO refinancings that have occurred in 2016, according to Deutsche. They account for the bulk of the six refinancings during the same period.
Overall, “the step-up feature has served to shorten the life of some of the tranches while others remain outstanding but paying a handsome coupon relative to similar tranches, i.e. AAA rated tranches of broadly syndicated loan CLOs that are nearing the end of their reinvestment periods,” Deutsche Bank states in its report.
The report notes that step-up tranches were largely designed to offer a bond that would “in practice” offer a shorter-than-average AAA maturity of two years, “even though technically it had same principal repayment and profile and maturity.”
“The idea was that if coupons rose significantly, then a refinancing would most likely take place – and if not, the higher coupon would be adequate compensation to the bond holder for having to hold on to the bond longer,” the report stated. Such a stepped-up note would have increased demand in the secondary market for a coupon “well over” a market-price coupon.
Deutsche Bank says there have been some 26 US CLOs since 2013 issued with step-up tranches. Three of them, including Neuberger Berman’s were created when original notes were refinanced. Of those deals, 23 have been in broadly syndicated CLOs and most were designed to have their coupon step up 18 to 24 months after closing. Many also offered an additional step up a year afterward.
Most of the remaining 17 deals have 20-35 months remaining before step-up provisions take place. Nine have tranches with outstanding coupons of Libor plus 175 basis points or higher, which given current levels of approximately 144 basis points should “likely” be refinanced, according to Deutsche Bank. None have coupons above Libor plus 190 basis points.
