S&P has raised the alarm on the steady shifting out of CLO loan maturities, warning even CLOs whose reinvestment periods ended some time ago are seeing a lengthening of their weighted average life, with potentially negative implications for investors.
“Even CLOs whose reinvestment periods have ended have seen ongoing changes in their underlying portfolio compositions and/or changes to the maturities of existing collateral,” says S&P.
Partly the shift out of loan maturities is being driven by the increasing prevalence of amend-to-extend (A2E) transactions in the European and US loan markets, says S&P.
Though not a new trend, the issue has become the most pressing concern for CLO investors as it now affects the majority of outstanding issues in the market.
To some extent the trend is a reaction to a dearth of leveraged loans in the market, squeezing supply by depriving managers of the assets needed to structure deals.
“The recycling of assets from redeeming CLOs into new structures is an interim part solution, a sticking plaster,” says David Bell, CDO business manager at BNY Mellon. “The longer-term solution is still dependent on primary issuance, which will rely heavily on increased M&A activity and or restructures.”
Investors are aware of the issue and “are quite vocal about this”, says Dagmar Kent Kershaw, head of credit fund management at ICG.
“They have no problem calling the manager to say they don’t want the deal pushed out and out. They will argue that if there is a problem with a company they would rather take the pain now and move on. But each case is different and has to be assessed on its own merits.”
S&P advises investors to be vigilant in accepting A2E terms, warning of unintended consequences, particularly a delay in the repayment of principal.
“Some A2E transactions create long-dated assets that extend beyond the CLO tranches’ legal final maturity date,” says S&P. “Some market participants may argue that accepting an A2E is preferable to the alternative of facing a loan default.
“However, since such loans will not repay principal before the CLO note principal is due, noteholders are likely to face market-value risk if these loans need to be sold in the secondary market to repay CLO note principal.”
The perspective will be different depending on which CLO tranche you hold, says Laurence Kubli, manager of the Julius Baer Multibond ABS Fund.
Senior tranche-holders are focused on the timing of repayment, meaning A2E is viewed less favourably, even if it is tolerated as preferable to a default. But for equity investors, who are at much higher risk of being wiped out altogether, timing is less of a concern and A2E is generally welcomed.
“The first question we ask when we see a new manager is for a copy of the prospectus so we can look at the language around the period following the reinvestment period,” says Matthias Wildhaber, manager of the Julius Baer Multibond ABS Fund. “We are looking for clear language – if there is any ambiguity, we won’t invest.”
In other ways, investors now have more influence over issuers than ever. Investor appetite for increasing the frequency of interest payments has driven an uptick in deals paying every three months, rather than every six, says one analyst.
The conditions put on CLOs dictating the terms of reinvestment outside the reinvestment period have also been changing. The prerequisite for ratings stability is in decline, with S&P observing all CLOs sampled in the 2004 vintage having this condition, declining to 75% for the 2008 vintage.
Conditions setting maximum allocations for certain asset classes is more prevalent, while covenant-lite is another feature that only came to prominence after 2007.
All this is happening against a turbulent backdrop for CLOs. Credit Rating Agency rules (CRA3) might be siphoning off demand for CLOs by making them more expensive.
“A lot of the loan borrowers that previously provided loans for CLOs have shifted into borrowing using high-yield bonds,” says ICG’s Kershaw. “Issuance there is at record highs and around 50% of new issuance is loan-to-bond refinancings.”
And the vacuum left by declining CLO issuance has started to be filled by direct lending funds, which have emerged as serious players in the past 18 months. They focus on smaller loans than the CLOs and might not appeal to all the same investors – not being the triple-A-rated paper preferred by the big institutional investors.
Yet this year has been a good one for CLO issuance, with 10 transactions coming in 2013 to date, up year on year, as the spread between the cost of funding a CLO and the returns that it will generate becomes favourable.
‘Skin in the game’ rules
The bigger unknown is what impact new ‘skin-in-the-game’ rules will have on the market, requiring managers to retain 5% of deals. Kershaw calls the rule “the biggest headwind facing the industry”.
From around 60 CLO managers pre-crisis, consolidation has brought the number down to around 35 to 40, which will likely half again, Kershaw predicts. The rules come into force in January, but deals that are put in place now do not look like they will be grandfathered, meaning the rules are effectively in place already, she says.
BNY Mellon’s Bell adds: “I would expect we will see further consolidation of managers able to deliver new CLOs, resulting in a core of six to eight institutions with the necessary capital to comply with the 5% skin-in-the-game directive.”
Mid-tier managers might find it problematic to accommodate the rule, though that might encourage more joint venture arrangements to facilitate a route to market, he says.
From an investor perspective, the skin-in-the-game rule looks like a step in the right direction, says Julius Baer’s Kubli. Issuance continues even after the European Banking Authority announced the rule, suggesting the rule might not undermine issuance as much as feared.
“Managers seem to be showing more dedication to the product, so it seems like a positive thing,” she says.