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Global credit funds & CLO's
September 2020 | Issue 227
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Opinion CLOs
Thomas Majewski
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The length of a CLO’s reinvestment period has no substantive effect on its resilience to defaults
Founder & managing partner Eagle Point Credit Management
September 2020 | Issue 227
Roll the clock back five months and five-year reinvestment CLOs were market standard. But by mid-March the realities of stay-at-home orders were becoming clear. We cancelled flights and everyone was busy figuring out how to log into Zoom.
In March, the US senior secured loan market delivered one of its worst ever total return months — down even more than the S&P 500. CLO triple As were trading with 400-plus discount margins (DMs) and prices were in the 80s.
Central bankers around the globe quickly dusted off their playbooks from 2008 and their swift action helped stabilise markets. Those actions have been so effective that recently the S&P 500 rallied past its pre-covid all-time high.
Through the ups and downs of the first half of the year, the secondary market for CLO securities — rated debt tranches, in particular — continued to function well. By July, more CLO bonds had traded in the secondary market than in all of 2019. And in the primary market, most CLOs are being structured using a three-year reinvestment template.
Demand for long tenor CLOs
Looking to the top of the stack, some could argue that triple A investors prefer short tenors, which allow them to be repaid quickly. However, the new issue market indicates that many triple A buyers want to lock in today’s spreads for longer. Indeed, a small number of CLOs have printed with non-call periods or make-whole provisions that exceed today’s standard of one year.
Why then is the primary CLO market stuck on three-year reinvestment periods? With today’s three-year reinvestment, one-year non-call convention, debt investors get less call protection than they would in a pre-covid structure (not good if you think the market will continue to tighten), and they don’t have the benefit of substantive additional credit resilience.
As a mezzanine debt investor, we would be happy to move out to a five-year tenor in reinvestment periods for new issue CLOs, in exchange for double today’s market standard for call protection. In a tightening market, we believe this is a fairly straightforward analysis.
Our hope is that others follow suit.
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Three-year reinvestment CLOs are the norm, but debt investors should be locking in historically wide spreads for longer
No preference for short tenors up top
As evidenced by their strong bids, many investors in the secondary market prefer CLO debt with longer remaining reinvestment periods. Indeed, late 2019-vintage and pre-covid 2020-vintage CLO debt securities are some of the most sought after in the market today. Some are even trading at premiums to par.
Regardless of your view on the ultimate shape of the current default cycle, for many CLOs there is no substantive difference between the resilience to defaults of CLOs with short or long remaining reinvestment periods.
In our analysis, the constant default rate that results in the first dollar of principal or interest impairment for a representative triple B CLO tranche is 50 basis points lower if the CLO has a five-year reinvestment period than if it has a three-year reinvestment period. In our view, such a difference is negligible.
In exchange for accepting a 67% longer reinvestment period (without a deterioration in resiliency), debt investors would be able to get two years of call protection. This is 100% longer than the market standard today. Considering many CLO debt tranches are trading in the high 90s, with a few bonds creeping over par, we believe the CLO debt market is not giving due credit to the value of long non-calls.
Some short-term-oriented investors might say that long-term bonds are more susceptible to price drawdowns. In the case of modest spread moves, that assertion holds some water.
However, during recent significant market moves — think Q4 2015 or Q1 2020 — short tenors for mezzanine CLO tranches did little, if anything, to stabilise the value of CLO debt securities. Indeed, in times of stress, the market typically shifts from a DM convention to a dollar price convention to quote CLO debt security prices. In a number of instances, we’ve seen short mezzanine tranches trade wide to longer mezzanine.
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