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February 2023 | Issue 252
Analysis
CLOs
Rope-a-dope brings knock-out returns
Charlie Dinning
Data journalist
Sam Robinson
Data editor
Post-pandemic US and European CLOs delivered mid-teen equity returns in 2022, despite a barrage of weak macroeconomic news and what could have been a heavyweight Libor mismatch
Once again, CLOs have shown their value against a backdrop of economic volatility. Headwinds such as the erosion of Libor floors, mismatches between Libor and Euribor tenors, and quiet loan markets, on the face of it, pointed towards a rare down year for CLO investors. But defying this expectation, US CLOs that went effective in 2021 and 2020 averaged equity payments of 15.73% and 14.83%, respectively. Their European 2021 and 2020 counterparts paid 16.77% and 16.48%.
Some firms don’t charge fees directly
GoldenTree Asset Management leads US CLO equity payments, averaging over 30% annualised. However, it and Fortress Investment Group (in third place) do not charge management fees within their CLO waterfall payments. Instead, the pair invest in the equity of their deals via funds that charge fees. This means the net annualised payments are not known.
2020-21 US CLOs: 2022 annualised payments to equity vs OC cushion*
*OC cushion as of Dec-22 Source: CLO-i
Diameter Capital Partners was the best performing US CLO manager that does charge management fees on its CLOs. The firm paid 22.41% annualised to equity last year, and it was the manager that traded the highest percentage of its portfolio (80%) in our analysis of US CLO trading between March and July 2022 (see October issue).
Trading was an important tool last year, according to Laila Kollmorgen, portfolio manager at PineBridge Investments. She says: “Managers that chose to have clean conservative portfolios would have taken a hit on equity payments because of the headwinds in the market last year. The managers whose distributions held were those that actively traded.”
*no fees charged **Correction: includes updated figures
In Europe, OCP Euro 2020-4 catapulted Onex Credit Partners into top spot as it returned 27.71% annualised last year. The deal was reset in August 2021 after a poor 2020 where equity payments averaged 3.75% annualised. The next eight managers in Europe were all between 20% and 21.5% annualised — figures that are all the more impressive considering the challenges CLO managers faced in 2022.
The US CLO market lost the benefits of a Libor floor in early 2022, but this was compounded by other factors. “The erosion of the Libor floor affected equity distributions at the beginning of the year, but the mismatch between one- and three-month Libor was a headwind throughout and got worse as the year went on,” says Kollmorgen.
Borrowers therefore made the decision to switch their payment frequency to one-month Libor to save money, and now around 60% of loan issuers are paying off one-month Libor, sources say.
At one point the mismatch between one- and three-month Libor reached 70 basis points, and the effects of this were seen in the Q3 and Q4 2022 payments, and also carried over into Q1 2023. In Q1 and Q2 last year, 2020 and 2021 US CLOs paid 18% annualised to equity. In Q3 this dropped to 14.64% and in Q4 just 11.05%.
2020-21 Euro CLOs: 2022 annualised payments to equity vs OC cushion*
*OC cushion as of Dec-22 Source: CLO-i
Europe faces benchmark mismatch
One portfolio manager states that “Europe faced similar headwinds to the US but on a slight delay” due to the European Central Bank not raising rates until after the Fed.
As a result, some loan issuers switched from six-month Euribor to three or even one-month tenor, which did not go down well with European CLO managers. Sources say CLO managers and investors are looking at removing one-month Euribor as a tenor.
“Managers with clean conservative portfolios took a hit on equity payments”
Laila Kollmorgen, Portfolio manager | PineBridge Investments
The effects of the mismatch in Euribor tenors was not as extreme in Europe because about 15% of the loan market and almost all fixed-rate bonds pay semi-annually, meaning they boosted Q2 and Q4 numbers, according to sources. But sources say that Q1 2023 equity payments will be down in comparison. Q2 and Q4 European CLO equity payments were above 17% annualised, but Q1 and Q3 were 14.15% and 16.59%, respectively.
According to sources, CLO equity payments could also be lower for newer CLOs if they have X notes, which are paid off in the first two years of payments. But in the long run these improve CLO equity IRRs and net asset value.
CLOs can also have M notes, which provide another way of dealing with rebates to equity investors, who may prefer them to side letters. However, part of the equity distribution goes through these notes, reducing the notional annualised payments.
Bond allocations are a differentiator
Bonds were a popular play in the US and European CLO markets, but timing was crucial sources say. Some managers came into the year with a high allocation to bonds and felt the effects of rising interest rates as the year played out. However, according to sources, bonds offered value if the managers timed the move right and could build par through the high yield market.
But one European manager also points out that high bond buckets mean there is a mismatch between a CLO’s assets and liabilities. Some deals can have up to 20% of the portfolio in bonds while only having one fixed-rate tranche that is worth €10 million (equating to 2.5% of a €400 million CLO), for example.
Managers were forced to look further afield amid the new issue loan drought in 2022 and the looming threat of downgrades. US CLO new issue loan market volumes were down around 70%, sources say, and the European market was “practically closed from March to October”.
With a lack of available credits, CLO managers were after a similar profile of loans for their portfolios according to people familiar with the market — mainly loans more likely to remain at single B, not be at risk of a downgrade, and that paid a higher coupon.
This demand led to bifurcation of the loan market, with high-quality borrowers expensive in comparison to the index and “at risk” credits sold off at prices below the index, and often below 90, sources say.
However, a European CLO manager says a lack of loan issuance could have been accretive to equity payments last year, as it meant CLO portfolios were more likely to be fully invested and earning on the entire portfolio rather than waiting on new issue loans to be settled in time for payments.
2022 also gave equity investors a chance to re-evaluate CLO managers and re-tier them. According to sources, a big part of manager tiering through 2022 was the glut of personnel moves, and mergers and acquisitions in the CLO market.
Methodology
- Data includes CLOs that went effective in 2020 and 2021. Bond-flex CLOs, middle market CLOs and reissues were excluded.
- Annualised return (%) is calculated assuming equity issued at par.
- Manager current OC cushion: OC result of junior-most test minus respective trigger, as of December 2022 trustee report or nearest available.
- Manager change in OC cushion: average change in junior-most OC test cushion from January 2022 to December 2022, or nearest available trustee report.
- Leverage figures calculated as of December 2022. WAS figures taken from January 2022 trustee reports or nearest available report.
- Off-schedule reset payments were combined with the nearest payment date for annualisation.
- All data is taken from CLO-i and Moody’s Analytics.
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Global credit funds & CLO's
February 2023 | Issue 252
Published in London & New York.
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