February 1, 2019 / 8:10 PM / 19 days ago

Shorter CLO reinvestment periods gain favor

NEW YORK, Feb 1 (LPC) - Some Collateralized Loan Obligation (CLO) managers are choosing to issue funds with shorter terms in order to counter rising spreads.

Among the first eight CLOs issued this year, just three had a standard, five-year reinvestment; the time in which the fund can purchase new loans, according to LPC Collateral data. PGIM priced a CLO last week with a seven-month non-call period and a one-year reinvestment, while CBAM priced a deal that includes a one-year non-call and a three-year reinvestment, according to sources.

Shorter terms allow managers to issue deals with a coupon typically lower than the market rate for longer-dated funds, often with the thesis that the CLO will be refinanced or reset in a year or two when the non-call period is over and market conditions may have improved.

“We are expecting more static deals and more short-duration deals in 2019,” said Rishad Ahluwalia, JP Morgan’s London-based head of CLO research.

CLOs are the biggest buyers in the US$1trn US leveraged loan market, which companies including Hilton Worldwide and Dunkin’ Donuts rely on for financing. As investors turned to the floating-rate debt as a hedge to rising interest rates – the Federal Reserve hiked rates nine times in three years – companies were able to take advantage of the demand to cut interest payments. Borrowers refinanced more than US$389bn of institutional loans in 2018, according to LPC data.

As the funds received lower interest payments from companies, they were forced to pay higher spreads to their own investors as CLO debt coupons increased amid a record US$128.1bn of US CLO issuance in 2018, according to LPC Collateral.

It was a double whammy for CLOs that were receiving less interest even as the funds were forced to pay higher coupons to holders of the Triple A tranche, the largest and most senior portion of the deal. This leaves less left over to pay holders of the most junior portion of the funds, the equity, who receive the remaining interest after all debtholders are paid.

When equity distributions decrease, the economics of raising a new fund becomes increasingly difficult. Wells Fargo said equity distributions for most CLO vintages decreased year over year, according to a January 31 report.

Triple A spreads were already widening, jumping from the low 90bp range for a handful of CLOs in March through May of last year to a December coupon high of 133bp, according to LPC Collateral. Citigroup is predicting spreads could move to the 140bp-145bp range by the end of the year.

Bank of America Merrill Lynch lowered its refinancing and reset forecast because of the widening spreads, dropping its prediction to US$55bn from US$100bn, noting spreads are too wide for most deals to be reworked, according to a January 25 report.

Issuing a CLO with a shorter reinvestment period ensures investors get their money back faster and in turn typically allow for a lower coupon. Once a reinvestment period is over, cash that otherwise would have been used to buy new loans is instead used to pay back investors.

The CBAM CLO Triple A tranche priced at 128bp over Libor and the PGIM senior piece priced at 118bp, the sources said. That compares to 137bp for a CLO from Sound Point Capital Management that has a two-year non-call period and a five-year reinvestment, according to a third source.

In January, Assurant priced a CLO with Bank of America Merrill Lynch that has a non-call period that expires in April 2020 and a reinvestment period that ends in 2022, LPC previously reported

ArrowMark priced a CLO without a reinvestment period, known as a static deal, with JP Morgan in January that includes a US$264m Triple A tranche with a 117bp coupon, LPC previously reported.

Spokespeople and representatives for the CLO managers either declined to comment or could not immediately comment. (Reporting by Kristen Haunss. Editing by Jon Methven)

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