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July 2023 | Issue 256

Question your assumptions

Poh-Heng Tan
Loan prepayment rates are a critical factor for investors valuing CLO debt and equity, but reality doesn’t match expectations in our study of seasoned deals in the European market
Valuing CLO paper is complicated, and loan prepayments are one of the trickiest parts. When pricing a new issue CLO, the market generally assumes that 15-20% of loans will prepay their principal annually. This prepayment rate is important because it essentially determines the pace at which a CLO’s rated debt is paid off after the reinvestment period, when the CLO pays down its own principal.
In this article we compare how close real repayment rates are to assumed rates for seasoned EU CLO deals. We also look at why, during the first two years of the post-reinvestment period, annualised prepayment rates appear to be lower than expected.
The speed at which CLO rated debt is paid down after the reinvestment end date depends on several factors, including the behaviour of the CLO manager, prevailing market conditions, the post-reinvestment end-date language of the CLO, and the composition of the collateral pool. Post-reinvestment end-date prepayment rates can vary significantly even between deals managed by the same manager.
Post-reinvestment prepayment rates for 55 seasoned European CLOs
Supporting net interest margin
Slow prepayment rates after the reinvestment period can offer advantages to CLO equity investors, as they help maintain low funding costs, and support the net interest margin of the deal (ie the weighted average portfolio spread, net of funding costs). Additionally, the trend in net interest margin plays a crucial role in generating income to offset any future collateral losses resulting from defaults or trading.
Debt investors generally prefer a quicker prepayment rate as it results in a faster pull to par. For instance, if a portfolio’s factor declines from 0.97 to 0.75 due to the absence of post-reinvestment period asset purchases, the credit risk exposure is reduced, while cash derived from prepaid or sold loan proceeds, which is allocated to flushing down the payment waterfall, carries no credit risk.
Conversely, a slower prepayment rate can extend the lifespan of the debt tranches, potentially increasing volatility, especially in deals with low market-value OC metrics. Based on this study, if debt investors see that the actual prepayment rates for a deal are low, they tend to assume even more conservative prepayment rates, which in turn reduces tranche prices for that deal.
We delved into a sample of 55 seasoned EU CLO deals with reinvestment end dates spanning from July 2018 to January 2022 and looked at their annualised collateral prepayment rates (based on the original collateral balances) in the first and second years after their reinvestment periods ended. As the chart on the previous page shows, most of the deals fell below the market assumed rates — in many cases far below. In fact, the median prepayment rate was just 1.8% in the first year post-reinvestment, and 5.7% in the second.
Impact of asset purchases
Next, we looked more deeply at the 25 deals that showed single-digit annualised prepayment rates during the first and second years following their reinvestment periods.
The managers of these CLOs purchased assets after the reinvestment end date, which caused the CLOs’ expected average prepayment rates (based on the original collateral balance) to be markedly reduced (see table, below right). On average, these deals saw a prepayment rate reduction of 15 percentage points, post-reinvestment period.
How did these managers achieve such high reinvestment rates after the reinvestment end date? The weighted average life (WAL) metrics of the underlying collateral pools in these deals, just before the end of the reinvestment period, were favourable, averaging around 4.8 years (with a range of 4.4 to 5.3 years). This gave managers flexibility to ensure the stated maturity of new assets was equal to, or shorter than, the maturity of the prepaid or sold assets they replaced after the reinvestment period ended.
Average alpha benefit of CLOs making post reinvestment purchases
Equity investors undoubtedly appreciate the continuation of reinvestment by CLO managers during the post-reinvestment period, especially in the first two years. However, ensuring the sustained credit performance of the underlying portfolio is also important — and a question arises as to whether European CLO managers indiscriminately acquire assets during the post-reinvestment period solely to extend the lifespan of a CLO.
In encouraging news for both debt and equity investors, an analysis of a subset of 19 EU CLO deals managed by 15 seasoned managers* with very low annualised prepayment rates during the first and second years following their reinvestment end-dates reveals that the alpha performance of these deals remains uncompromised. In fact, these deals, on average, outperformed the other 71 seasoned 2015–19 vintage deals managed by the same managers (see chart, below).
Alpha performance of European CLOs with low post-reinvestment repayment rates (bp)
** 71 other deals (vintage 2015-2019) managed by same managers as 19 deals
The top line represents the average alpha trend for the 19 deals. In July 2021, the average alpha for these deals stood at 14bp — approximately 2bp higher than the average of the other 71 deals managed by the same managers. An average alpha of 14bp indicates that, on average, the underlying portfolios of these CLOs outperformed the Morningstar European Euro Denominated Loan Index by 14bp on an annual unlevered basis, covering the period from the deals’ closing dates to their last reporting dates in July 2021.
To put this in context, European CLO managers typically receive total (senior and subordinated) management fees ranging from 45–50bp for managing CLOs.
As of 6 June 2023, the average alpha of the 19 deals surpassed the average alpha of the other 71 deals by 12bp. In other words, the credit performance of these 19 deals proved more resilient than the other 71 deals, which suggest European CLO managers have selected appropriate credits during the post-reinvestment period, despite the additional constraints imposed.
* Alcentra, Apollo, Blackrock, BNPP AM, Cairn, Carlyle, CSAM, CVC, Five Arrows, ICG, Investcorp, KKR, Oak Hill, Spire and Tikehau
  • Data was sourced from Intex, Pitchbook LCD and Refinitiv’s LPC.
  • Prepayment data is taken from the most recently available payment reports.
  • To arrive at the total return alpha, the total gross return for each period is calculated by compounding the portfolio monthly (or periodic) total return since the closing date. The total portfolio return for each CLO deal is then annualised, and the excess return over the index’s annualised return is the total return alpha. The benchmark loan index used for this study is the Morningstar European Euro Denominated Loan Index.
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Global credit funds & CLO's
July 2023 | Issue 256
Published in London & New York.
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