The Great CLO Refinancing is Well Underway
After the most volatile year that we have seen in decades, 2021 feels very different. Expectations for high yield and leveraged loan default rates have dropped materially, largely as a consequence of extensive government support during the various lockdowns helping businesses remain solvent.
Since the summer European collateralised loan obligation (CLO) spreads have recovered sharply, and more recently we’ve seen very strong demand from investors looking for floating rate assets pushing spreads tighter. With AAA CLO notes now trading close to pre-COVID levels (just 5-10bp wider), CLO managers are taking the opportunity to consider their options for locking in cheaper financing.
The CLO primary market has come back to life fairly quickly after the rapid sell-off and subsequent recovery across the second half of 2020. If we look at the deals that were done late last year we can see that AAAs were generally priced at a euro yield of around 1.1%, while mezzanine tranches were still a bit wider than where they started 2020 with BBBs and BBs trading at around 4% and 6.5%, respectively. So far this year we have seen various CLO refis and resets (a refi is essentially a repricing and a reset is closer to a brand new CLO with the existing collateral) as well as a number of new CLOs. We expected to see a lot of this refi and reset activity to start from Q2 onwards, but given the sheer amount of deals that are now callable this has started earlier than we expected.
We’re generally a big fan of resets, especially as a lot of these mezzanine bonds tend to trade at a discount to par, so there can be plenty of potential for capital gains. At the reset date CLO bondholders get the option to either roll their existing holding into the new deal or to get par back early, with the latter often a good option as long as there is a busy primary market in which to redeploy the proceeds. Fundamentals look to have improved materially and most collateral pools are in a good state, but we have seen sponsors putting more equity on the table as debt investors typically require the leverage to drop if there’s a higher exposure to industries most sensitive to COVID-19 lockdowns, to build in a little more protection.
In addition, Bloomberg has reported that there are 17 CLO ‘cleansing notices’ out, an early indication that the CLO manager is looking to refi/reset their CLO in the coming weeks. In January five CLOs were successfully refi-d or reset and we understand managers such as PGIM, CVC and ICG are trying to get more of these done soon. In the meantime brand new CLOs are still attracting a lot of interest and deals have been well oversubscribed. Last week KKR managed to issue a CLO with the AAAs priced at a yield of 0.83%, in line with pre-COVID lows, and the junior bonds traded at levels tighter than where we have seen comparable secondary paper (BBBs and BBs at 2.9% and 5.6% vs. secondary at 3.2% and 6%), but the primary and secondary spreads will likely realign relatively quickly, as they normally do.
The 2020 CLO vintage is one of the most obvious to look to refinance this year, as well as deals done in 2016-2018 which are reaching the end of their reinvestment periods, so in terms of primary/refi/reset supply 2021 could prove to be a very similar year to 2018, a year of multiple resets and tightening spreads. And with inflation fears (mostly) in the US creeping in, a search for floating rate assets will probably only increase.
I think it’s likely we’ll see new cycle tights for the European CLO sector this year, so in addition to healthy income we believe there is plenty of room for capital appreciation as prices are being pushed higher in the secondary market. Clearly uncertainties remain ahead of us, but currently the outlook appears strong.