Calling All (Eligible) CLOs

Collateralized loan obligations (CLOs) are becoming victims of their own success.

Spreads in the primary market have tightened so much over the past couple of years that holders of the most subordinated tranches of CLOs (also called the “equity”) that were issued as recently as 2011 are expected to call them this year in order to fund new deals more cheaply.

That means investors in the more senior tranches of these transactions will have to find other places to put their money to work, most likely in lower-yielding assets.

Call activity is a constant for CLOs, which have final maturities of 10 years or more but can only purchase new collateral for the first three to five years of their life span and are typically eligible to be called even earlier.

Analysts at Wells Fargo have tracked 75 CLO redemptions that occurred between the start of 2011 and February 2013, according to a report published Feb. 11. In aggregate, these redemptions amounted to $35 billion in original balance, or $16 billion in outstanding balance, at the point of redemption.

However, many of these deals were issued in 2003 and 2004 and had already exited their reinvestment periods and begun paying down senior bondholders’ principal, reducing returns to investors in the most subordinated tranches.

Going forward, much of the call activity is expected to come from more recent-vintage deals that are still able to reinvest proceeds from payoffs of the loans in their pools of collateral.
Analysts at the Royal Bank of Scotland (RBS) say that there are 34 CLOs issued in 2010, 2011 and 2012 that will be exiting their non-call periods in 2013, with the bulk, or 26, coming from the 2011 vintage.

The question is, “How long will these deals remain outstanding, given the recent tightening in CLO liability spreads?” said Richard Hill, a director of CLO and CMBS strategy at RBS.

Hill noted that triple-A bonds issued by CLOs at 155 basis points over LIBOR in 2012 can now be issued at closer to 120 basis points over LIBOR, “which potentially means a greater return to equity.”

Another reason that recent-vintage CLOs are likely to be called: they are often an easier, and less expensive, transactions than would be the case for so-called legacy transactions issued before the financial crisis.

Equity holders in CLOs issued pre-crisis generally have only the option to either call or refinance these deals. When a deal is called, the collateral manager sells the collateral at current market prices and uses proceeds to repay note holders; when a deal is refinanced, it issues a replacement class of notes and redeems the original notes. In both cases, proceeds must be sufficient to at least repay the existing notes at par.

By comparison, more recent deals provide for a third option: repricing. In this scenario, it is not necessary to repay the principal of all note holders, just the principal of the investors that do not agree to accept a reduction in the spread on their notes. This is typically much easier than acquiring a loan to redeem notes or issuing one class to retire another.

“We believe that repricing language in new issue CLOs gives equity holders a distinct advantage compared to legacy deals, especially in a spread-tightening scenario for the underlying loans,” Hill and fellow CLO analyst Kenneth Kroszner wrote in a Jan. 11 report.

Steven Oh, who heads the leveraged finance group at CLO manager PineBridge Investments, said that refinancing may be the most likely outcome for many 2011 vintage deals. “Given the scarcity of portfolio assets, it may be beneficial to move the entire portfolio into a new transaction, especially those with a tightly knit equity investor base,” Oh said.

“The current market yields can induce the existing debt lender to reinvest and do it at an attractive spread relative to alternative options.”

PineBridge has brought 16 CLOs to market, two of them in 2012. The firm has over $8 billion under management in CLOs and other forms of leveraged finance, according to information posted on its website.

Wells Fargo CLO analyst Dave Preston also sees the potential for deals priced in 2010 and 2011 to be called, refinanced or re-priced. However Preston thinks that there is a more compelling case for some managers to do this than others, given the wide disparity in triple-A spreads in these vintages. “While some are much higher than current market levels, the deals with spreads in the 120-130 basis-point range may be less likely to be called or have the senior notes refinanced,” he wrote in the Feb. 11 report.