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Opinion CLOs
A reset can position a CLO for the drawdowns that follow a bull market
by Thomas Majewski
Thomas Majewski
Founder & managing partner
Eagle Point Credit Management
Extending a CLO’s reinvestment period is usually the best option — but timing is important
With so many CLOs being reset or refinanced, we find ourselves thinking back to 2021, when USD 150bn of the USD 250bn total issuance that year was from resets or refinancings. In our September 2021 column, we addressed this trend, considering why CLOs are reset, refinanced or called. Many of the same decision-making criteria apply today.
With triple A spreads tightening into the 130s, a significant portion of CLOs issued in the past five years have debt tranches that are now prime for a reset or refinancing. At the same time, loan prices have risen, leading to an increase in CLO liquidations as some CLO equity investors seek to take their chips off the table for seasoned CLOs. With today’s surge in reset/refi activity, combined with increasing CLO calls and billions of triple A paydowns, we expect net-negative supply of CLO triple As in the second half of the year. This should push triple A spreads tighter.
Similar scenarios have happened in 2017-18 as well as 2021, where strong markets led to simultaneous surges in resets/refis and liquidations. In our column from 2021, we highlighted that as a result of a steeper term curve for triple As (particularly during the 2017-18 period), many traditional buyers of long-dated paper were repaid through CLO refinancings. If you owned a large portfolio of two-year seasoned CLO triple As and sat still, your portfolio may have shrunk by more than 25% in a short period.
That trend is a little different this time, as there is less of a term curve for triple As and many third-party equity investors now have a greater appreciation of longer reinvestment periods. For CLO equity investors, facilitating active management of loan portfolios within CLOs was a must, as it is now. That fact became more widely understood by equity investors who owned post-reinvestment period CLOs going into COVID back in early 2020.
Our preference normally is to reset. Extending the reinvestment period positions the CLO to take advantage of potential market drawdowns that follow bull markets. This is also delights CLO collateral managers, who see their fee streams extended.
Refinancings can be a powerful tool to increase equity cashflows and today typically occur in CLOs where there has been above average par loss. Sometimes, the term curve is steep enough that opting just to refinance at a tight price is worthwhile, even without accumulated par loss. That said, when doing so, you are typically adding a new non-call without extending the reinvestment period, and investors should be careful that they don’t end up owning non-callable post-reinvestment period CLOs. With the term curve being reasonably flat this year, there has been much less refinancing activity compared to resets or calls.
Calls are often exercised when neither a reset or refinancing make economic sense. Typically, the payments to equity are dwindling (likely from triple A amortisation) to a point where unlocking the final terminal NAV value is the most attractive option. There are also times when one might have a portfolio purchased at a low price that has run up in value, and a call might lock in a great IRR. While resets may be CLO collateral managers’ favourite option, calls are usually their least favourite. Making sure your called CLO’s portfolio is liquidated in a way that maximises equity value is an important part of being an equity investor. In the case of some calls, conflicts arise and keeping a close eye on the process is essential.
Sometimes it’s better to wait
In some cases, it might make sense to do nothing with a CLO. This is especially true if you have a small portfolio of CLO equity and you think spreads will keep tightening. If you reset a CLO today and triple As tighten further, you’ve given up the option to reset at those better levels. This is a market timing call, but is an important part of any investment strategy. That said, if you have a larger, more diverse portfolio of CLO equity, you can reset some today, and still have more to do tomorrow.
Another relatively new segment of the market are CLOs where the equity is held within captive funds controlled by the CLO collateral manager. It is important to understand how these CLOs will behave. For some, we’ve seen non-economic behaviour by the equity held in captive funds. CLOs that should be called aren’t. Resets are delayed so new CLOs can be issued. While frustrating for the LPs in those funds, this can create opportunities for CLO debt investors, who can buy high-coupon callable bonds.
By looking to history and maintaining a clear strategy on resets, refinancings and calls, CLO equity investors can create a tremendous amount of long-term value for their investors in a strong market. But active management of a CLO equity portfolio is essential for success.
