News

CLOs becoming too equity-friendly?

Wednesday 11 April 2018 13:56 London/ 08.56 New York/ 21.56 Tokyo

Loosening documentation and a greater proportion of income being distributed to subordinate noteholders have sparked concern that US CLOs are becoming too equity-friendly. Nevertheless, headwinds may be approaching for equity investors as a result of a Libor mismatch.

Respondents to JPMorgan’s Q1 US CLO investor survey suggested that some documentation has become too “equity friendly”, highlighting the growth of features, such as longer reinvestment periods (which are now more commonly five years versus four years) and flexible post-reinvestment language. In particular, respondents commented that par flush language is “pushing the envelope” in terms of being overtly equity-friendly. They also pointed to other equity-friendly features, including length of WAL test relative to length of reinvestment period.

Moody’s also recently noted that allowing CLOs to erode par more easily can benefit equity holders, as it has become more common for CLOs to treat trading gains as interest proceeds rather than principal proceeds. This then allows cash to leak from the deal to equity holders, rather than to be used for reinvestment or to amortise notes.

The agency warns that other factors, such as managers being able to more easily alter a CLO’s risk profile, along with greater ease in amending governing documents could lead to weakening CLO credit profiles. However, it states that this loosening isn’t necessarily seen across the board and that it is mitigated to an extent by the structural quality of CLO 2.0 deals.

Meanwhile, triple-A notes have experienced the largest fall in the relative share of CLO income. In a new report, S&P finds that investment grade notes now take a smaller share of the income compared with the first post-crisis CLOs, while speculative grade notes receive more.

Excess spread is at its highest since the CLO market revived post-crisis. This indicates further that subordinated noteholders are receiving the highest share of the income.

S&P highlights that in 2017 pricings resulted in significant reductions in the relative margin for investment grade notes. The agency adds that for speculative grade notes, although 2017 relative margins were down from the highs of 2016, they exceeded the levels seen in 2015 or earlier.

While these trends may imply a more attractive environment for CLO equity investors, Morgan Stanley CLO strategists suggest that the rise in one-month and three-month Libor is likely to cause headwinds for the sector. The increasing three-month Libor rate has resulted in a higher absolute coupon contribution from the benchmark rate. As a result, the benchmark rate now accounts for 73% of CLO triple-A yield-to-maturity.

For equity investors, however, an asset-liability benchmark mismatch has emerged because around 50% of CLO collateral is benchmarked to one-month Libor - thus creating negative exposure to an increasing three-month to one-month Libor basis. Consequently, the Morgan Stanley strategists estimate that for a ten times leveraged deal with 50% one-month Libor assets, the annual equity cash returns would be 2% lower if the current 40bp three-month to one-month Libor basis environment persists.

11/04/2018 13:56:24