CLO Refinancings Surge as Managers Seek to Sweeten Deal Terms

(Bloomberg) -- Refinancings and resets of U.S. collateralized loan obligations may notch a fresh record this year as risk premiums narrow, allowing portfolio managers to lock in better terms.

Wall Street has increased estimates for the transactions with Deutsche Bank AG predicting $193 billion -- with $115 billion of that coming in resets -- and Bank of America Corp. raising its 2021 forecast by $80 billion from November to $140 billion. The record to beat was set in 2017, when $165.8 billion of the deals were sold, according to data compiled by Bloomberg.

CLO spreads have tightened in the new-issue market, and that allows the portfolio managers to get sweeter terms on deals they already sold. The expected rush has already been borne out with at least 14 of the 19 deals marketing or priced so far this year coming as a result of refinancings or resets.

“Refinancings and resets make a lot of sense if spreads tighten in the new issue market,” Jerry Ouderkirk, senior managing director and head of structured credit at Pretium Partners LLC, said in an interview. “It is wholly appropriate for the CLO manager community to be aware of where new-issue pricing is, and to lock in better terms, to the extent that the market offers it.”

While the recovery in CLOs lagged other sectors such as corporates following the pandemic carnage, the eventual spread tightening to near pre-Covid levels helped to improve the so-called arbitrage -- the gap between the interest earned from the underlying leveraged loans and the cost of borrowing to purchase the assets. A healthier arbitrage enhances the economics of the transactions, which makes it easier to attract CLO equity capital to sponsor new deals.

Exiting Non-Calls

Besides the ongoing tightening of CLO liabilities, the surge in refinancings is also due to the record volume of CLOs exiting their non-call period, Deutsche Bank analysts wrote in a Wednesday note.

About 80% of outstanding deals, worth about $505 billion, will have exited their non-call period by the end of 2021. Of those, about 27% will do so during this year, the bank said. Deals issued in 2020, mostly structured with one-year non-call periods in the aftermath of the pandemic to entice investors, account for $40 billion of this.

Reset transactions differ from refinancings as issuers are able not only to reprice at a lower rate, but also may tweak various features of the existing CLO in different ways, including shortening maturities. CLOs, which securitize bundles of leveraged loans, typically last about four to five years before their managers sell the portfolio, pay the CLO bondholders and give the remaining cash to investors in the riskier equity part of the deals.

Starting in about 2016, CLO resets and refinancings became much more prevalent, as repricing deals and changing terms more frequently can reduce the rates issuers pay to bond investors -- effectively the managers’ cost of funds. Issuers can refinance or reset existing CLOs as many times as they like, if the economics make sense and the deal is out of its non-call period.

Read more: Wall Street Games the CLO Machine to Stay Ahead of Downturn

Because senior-rated CLO slices have largely retraced all the spread widening experienced beginning in March, attractive relative value can only be found much deeper down the capital structure in new-issue transactions, market observers say.

“CLO BBs and equity are the most attractive now, in terms of relative value,” Tracy Chen, head of structured credit at Brandywine Global Investment Management, said in an interview. “High yield and corporates retraced all the widening, but CLO BB tranches only retraced 65%, so it still has 35% to go. CLO equity is the same story. That’s why there’s value there.”

Relative Value: CLO

• Goldman Sachs Asset Management believes that AAA-rated CLO spreads are attractive relative to investment grade corporate credit, analysts wrote in a recent research note
• Across all tranches, CLO spreads tightened to near pre-Covid tights in the fourth quarter, though the bulk of this tightening occurred in October
• CLO spreads were relatively unchanged in December, lagging spread tightening seen in the broader credit market

Quotable

“BBBs and single-As are the sweet spot for CMBS right now” in terms of relative value, said Brandywine’s Chen. “CMBS BBB is so much wider than high-yield BBs, and CMBS single-As are wider than corporate BBBs. You could argue that the valuation anomaly in CMBS is logical because fundamentals are so dicey in retail and hotels, but if you believe in the recovery and effectiveness of vaccines, you can dig deeper and find nuances in collateral quality and sponsor strength. You can find which retail properties and hotels can survive.”

What’s Next

ABS deals in the queue for next week include Oak Street (triple net lease), American Credit (subprime auto), DriveTime (subprime auto), Ford Motor (prime auto), Mercedes-Benz (prime auto), CarMax (prime auto), and ITE Management (railcar ABS)

©2021 Bloomberg L.P.