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Global credit funds & CLO's
March 2024 | Issue 262
Published in London & New York.
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March 2024 | Issue 262
Analysis
CLOs
How many CLOs will be called this year?
Poh-Heng Tan
Most CLOs are called when loan market prices are high. Distributions and equity NAV are also important, and they suggest that over 30 2017 and 2018 deals are now ripe for redemption
Despite the dramatic wave of resets and refinancings this year (as discussed in our reset and refi analysis here), the traditional end for a CLO has been an early call and redemption. That continued to a certain extent last year — by our count, 52 deals were called in 2023 and early 2024. So what factors can prompt CLO equity investors to call a deal?
If the conditions are right, CLOs can be priced with the intention, or at least the hope, of an early redemption. Many 2020 deals were issued aiming to capitalise on potential portfolio market value gains by purchasing heavily discounted loans. On average, these deals saw their last equity distribution at about 3.4 points before redemption. This statistic is based on 20 redeemed US CLO 2020 vintage deals, which had an average call time of just over one year. Similar trends were observed in many 2022 deals, albeit to a lesser extent compared to those from 2020. But those were two exceptional years. Excluding the 2020 and 2022 vintages, the average time it takes for post-2012 US deals to be called is 5.1 years.
1: US CLO calls vs average loan price
* Morningstar LSTA U.S. B-BB Ratings Loan Index average bid price
Source: Intex, Pitchbook LCD, CLO Research
Deal deleveraging post-reinvestment
In normal vintages, deal deleveraging during the post-reinvestment period is an important factor. Rapid prepayment rates, particularly in the first one to two years after the reinvestment period ends, can significantly reduce a CLO’s leveraged structure. This reduction, combined with an increased cost of funding as the AAA tranche is retired first, markedly increases the likelihood of full redemption by equity holders.
The most notable impact of this is on equity distribution, which can be adversely affected. CLO Research estimates indicate that 50% of US CLO deals were called when their collateral pool had a factor of at least 77.5%, and 75% were called with a factor of at least 49%. It is common for many US CLO deals to experience a prepayment rate exceeding 25% in the first two years post-reinvestment.
If equity payments drop below, for instance, two points on a seasoned deal, it might not justify the potential swings in CLO equity NAV to keep the deal outstanding, especially when the loan market has become volatile. In any case, two points is simply too low, especially for primary investors. In today’s environment, lower mezzanine debt investors can easily do better than two points each quarter. In fact, on average, the last equity distribution registered for around 500 redeemed US CLOs (2012–2022 vintage deals) was around 2.1 points before redemption.
Equity investors that acquired the majority equity tranche at a lower price in the secondary market may find liquidating the deal in a strong loan market more favourable than selling the equity paper, making it sensible to call the deal.
2: Proportion of deals called by average loan price (pp)
Source: Intex, Pitchbook LCD, CLO Research
Combining equity and debt
Even if a majority equity holder didn’t buy a deal’s equity at a significant discount, it may still find advantage in calling a deal if it holds a significant stake in discounted CLO debt within the same transaction. This is due to the greater gain from pull to par on the discounted debt, where the liquidation proceeds from BB/B/equity tranches exceed their market value.
The decision isn’t easy though. In hindsight, some investors might have been better off holding onto their equity/B/BB bonds rather than calling them in 2020 (although the cash they received could be used to take advantage of market conditions at that time).
Resetting an underperforming deal is challenging, especially if it requires injecting new equity cash. It might not make sense to pursue further investment in a failing deal. If a deal is primarily owned by one equity investor, resetting may be more straightforward, yet it remains a low probability action, as it raises questions about a manager’s performance.
Look to the loans
A strong loan market always presents an opportune moment to call a seasoned deal.
Chart 1 (opposite) illustrates the trend in US CLO deal redemptions, highlighting that the highest number of deals were called in 2021. This was closely followed by 2017 and 2018, which were also periods characterised by strong loan prices, as evidenced by the Morningstar LSTA US B-BB Ratings Loan Index average bid price exceeding 99.
The likelihood of deals being called depends to a large extent on the strength of the loan market. Around 85% of deals were called when the index’s bid was over the 97.8 level (see chart 2). As of 29 February this year, the year-to-date average bid of the index was 98.5.
5.1years
Average time to call for post-2012 redeemed US deals
Equity holders make the call
Given all of this, how many CLOs might be called this year? The final decision rests with the equity holders, and some factors like purchase price are private. But historically, the median last distribution for redeemed deals was around 2.1%. Currently, approximately 207 US CLO deals that have exited their reinvestment periods paid less than 2.1% in equity quarterly distributions on their last payment dates in January 2024.
Of these 207 deals, about 67 are better positioned for redemption as they have an equity NAV exceeding 10 percentage points, based on asset prices as of 28 February 2024. Most of those deals originate from the 2017 and 2018 vintages, as shown in the table below.
Is CLO debt at inception modelled too conservatively?
Generally, CLO debt tranches are modelled to run to maturity based on specified prepayment rates. If a deal experiences higher prepayment rates, it deleverages more quickly and could be called earlier.
If the yield term structure is upward-sloping, debt investors may receive a wider spread for a shorter-than-anticipated deal duration. If the primary CLO debt tranche is priced at a discount, this would lead to debt investors benefiting from additional spreads.
For CLO equity investors, modelling a deal to maturity can be problematic due to the difficulties in predicting portfolio prices at redemption.
For debt holders, the situation is more straightforward, as they are repaid at par upon redemption, even when certain portfolio price assumptions are applied in their base scenario. They may therefore wish to let a deal run to maturity.
While the BB tranche impairment rate is low, there are a number of ‘zombie’ deals outstanding, in which remaining collateral values are insufficient to cover CLO liabilities.
If the yield term structure is upward-sloping, debt investors may receive a wider spread for a shorter-than-anticipated deal duration. If the primary CLO debt tranche is priced at a discount, this would lead to debt investors benefiting from additional spreads.
For CLO equity investors, modelling a deal to maturity can be problematic due to the difficulties in predicting portfolio prices at redemption.
For debt holders, the situation is more straightforward, as they are repaid at par upon redemption, even when certain portfolio price assumptions are applied in their base scenario. They may therefore wish to let a deal run to maturity.
While the BB tranche impairment rate is low, there are a number of ‘zombie’ deals outstanding, in which remaining collateral values are insufficient to cover CLO liabilities.
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