Do resets help CLOs perform better?

Seasoned deals were active during a substantial period of very low interest rates. When the reset window opens, many will reset to lengthen their reinvestment period and gain additional WAL test cushions, putting them in a better position to take advantage of long-dated new issues as well as amend-and-extend deals.

However, in a strong loan market, loans will be repriced, and spreads will be compressed again. This may lead to mediocre median cash-on-cash annual distributions for more seasoned US CLOs. Additionally, annual distributions may decline if a reset deal includes a class X tranche or it pays down its liabilities. A low cash-on-cash annual distribution will cap the eventual equity IRR of a deal unless the final CLO equity NAV is above the primary issue price — and CLO equity tranches typically yield a low final equity NAV compared to par, given their first-loss nature.

Resetting a CLO may be challenging if the deal has experienced a significant decline in collateral market value. Under such circumstances, pricing the long-dated liabilities can become prohibitively expensive, especially at the mezzanine levels, regardless of otherwise favourable market conditions. The correlation between deal performance and market conditions is shown by the fact that 93.5% of reset deals were priced when the bid price of the Morningstar U.S. B/BB Ratings Loan Index was at 98 or higher.

Slightly over three-quarters of the seasoned CLO equity tranches from the years 2012 to 2015 have already fully recovered at least 100% of their tranche notional. This means that many of these equity tranches will not be dependent on their final NAV to achieve a decent IRR.

For older deals, the median annual distributions were largely in the 12-13% range. However, the median 2015 vintage deals stood out with an impressive 14.1% distribution. The reasons for this outperformance include, first, that the 2015 deals utilised fewer class X tranches, and secondly, that the 2015 deals saw a large first distribution.

One example from that vintage is York CLO-1, which was called recently. Given its outstanding annual distribution of 16.3%, which places it among the top quartile for 2015 vintage reset deals, it’s final equity NAV (which is likely to be in the low-30s), did not prevent it scoring a final IRR of at least 12.0%.

*As of 31 July 2023

As deals come out of their reinvestment period, they tend to be regarded more as principal value trades rather than income trades. Looking back, post-2012 deals were typically called when their last distributions averaged around 2%. However, the range of their last distributions varied significantly, spanning from 0% to over 4%. On average, the loan index bid price when deals were called was around the $99 level. Only about 10% of deals were called with the loan index below the $96 level. Some investors opted not to wait for their deals to pay down further, as this would lead to a decrease in their distributions to a low level. This decision is particularly relevant given that new issue BB tranches yield 12-13% on an annual basis in today’s market.

A good percentage of 2015 and 2016 vintage deals may still have a bit of runway ahead. But the median 2017–2020 vintage deals definitely have a good amount of reinvestment period remaining — an advantage in today’s higher interest rate environment, provided that any increase in distributions can effectively offset any increased losses resulting from trading or defaults.