April 2021 | Issue 233
CLO managers who struck the right balance in 2020 are more easily able to reset their deals
Patricia Antonios
Director Eagle Point Credit Management
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CLO managers were re-evaluated during the pandemic, and outperformers can expect to see benefits this year
The resilience of CLO debt surprised many in 2020. In particular, we were impressed by how quickly levels bounced back and the new issue market reopened.
Despite the large price swings in both the loan and CLO markets, total returns for all rated CLO mezzanine tranches ended positive in 2020. JP Morgan’s CLOIE index cited approximately a 3%-plus return, with double Bs generating the highest return at over 8%. As of last month, top tier new issue single A and triple B spreads are roughly back to pre-covid levels, with triple As and double As nearly 10 to 15 basis points tighter.
The durability of CLO debt relies on a number of factors. Loan default rates did not spike and, by the end of 2020, loan prices recovered sharply and retraced 90% off their March lows, with about a quarter of loans held by CLOs trading above par.
Closer to home, the structural mechanisms within CLOs and the non-mark-to-market asset reinvestment construct allowed the asset class to do what it was intended to do, with no frenzied forced selling. The CLO structure was further validated as breaches of over-collateralisation cushions were cured through paydowns, while cash flows were diverted and reinvested into lower-priced collateral, thus building par and improving metrics for the long term.
CLO collateral managers played an integral role in the sustained performance and recovery of CLOs in 2020 through credit selection and trading. This is evidenced by the fact CLO collateral outperformed the broader loan market in defaults, as CLO managers were proactive in repositioning their portfolios and mitigating losses.
Reshuffle of CLO manager tiers
The diversity of CLO platforms provided dispersion and investing opportunities, which the covid pandemic magnified. Many CLO investors, including Eagle Point, re-evaluated CLO collateral managers’ performance. This translated to a recalibration and reshuffle of CLO collateral manager perception, exhibited by new issue liability pricing and secondary trading levels.
For example, some CLO managers sold triple C loans too soon or not at all, and the different styles’ effect quickly became apparent. CLO managers with high triple C exposure pre-covid were especially impacted by the punitive rating agency downgrade wave that hit the US leveraged loan market during the pandemic. This resulted in severe breaches to existing triple C buckets and OC tests, limiting managers’ flexibility to take advantage of volatility and reinvest. Ultimately, this hurt performance and these managers now typically trade wider than they did before 2020.
Other CLO managers were more defensive at the onset and actively sold to reduce triple C exposure. These managers crystallised more losses compared to those that held on to strong conviction credits and chose to weather the storm instead.
The group who achieved the right balance maintained par and market value as loans were upgraded and prices appreciated. Now their paper not only trades at higher prices and tighter spreads, but they are more easily able to reset their deals and extend reinvestment periods. Those that experienced more par deterioration and market value losses are left with only the refinancing route.
In the current market environment, the resilience of CLO debt is again in focus due to the sharp rise in interest rates. Floating rate CLO debt can deliver an attractive absolute and relative return versus fixed-rate alternatives.
Even given this year’s elevated supply and rapid pace of primary, resets and refinancings, the CLO debt supply is being reasonably well-absorbed. Though there has been weakness from the glut of supply, especially in lower mezzanine debt where investors are more cautious, we have not observed extreme widening in levels.
There remains support from existing and new investors with cash to put to work. We expect dispersion and opportunities to persist, likely paired with bouts of price volatility, allowing CLO market veterans to continue to find value in CLO debt.
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Global credit funds & CLO's
April 2021
| Issue 233
Published in London & New York.
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