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Tracking potential returns to issuing CLO equity

admin | March 8, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

A CLO typically builds a portfolio of leveraged loans and finances it with equity and rated debt. The difference between the return on loans and the cost of debt flows to equity. It’s not a true arbitrage as much as a form of spread lending. Estimating potential equity returns can be complex, but a simple benchmark can signal changes to likely CLO demand for leveraged loans and supply of CLO debt and equity. The latest numbers suggest that after the market works off a slight hangover from late 2018, healthy CLO issuance should follow.

The complexity of actual CLO equity returns

The potential profits to CLO equity turn on only a few major cash flows: the returns from loans, the interest paid to debt, the costs of managing the CLO and losses from loan default. Each of these cash flows can vary over time, and the most sophisticated analysis considers a wide range if not all of the possible cash flow combinations. That’s where the complexity starts.

The potential cash flow combinations can seem overwhelming. Portfolio return can vary as the yield curve, credit spreads and other market conditions re-price available leveraged loans and as the manager trades and reinvests the portfolio. Interest paid to debt can vary with market conditions, across managers and as the equity holders exercise options to refinance or reset the debt. And while CLO management costs probably are largely predictable, losses from loan defaults can vary with economic conditions, borrower and collateral quality and loan covenants.

Building a simple benchmark

Despite the complexity, it still helps to have a benchmark of whether potential profits to equity are getting better or worse. A benchmark may not pinpoint potential equity return for any one manager or any one deal, but it can signal trend. That should help the leveraged loan and CLO market anticipate the potential CLO bid for loans and the supply of CLO equity and debt.

As a simple benchmark, Amherst Pierpont has put together a point-in-time estimate of profits to CLO equity with a few components:

• The income from a fully invested portfolio of leveraged loans priced at par with the coupon estimated from the S&P/LSTA 100 index of BB/B loan yields. This assumes a constant spread to the loans’ indices over the life of the deal and that the manager always reinvests at that spread.
• The cost of debt from issuing ‘AAA’ through ‘BB’ tranches at par at spreads indicated by the Palmer Square CLO discount margin indices and using a fixed structure (Exhibit 1). The fixed spreads and fixed structure imply that the manager never refinances or resets the deal.

Exhibit 1: Benchmark CLO structure

Source: Amherst Pierpont Securities

• Recurring annual operating costs for deal expenses and manager fees for the life of the deal (Exhibit 2).

Exhibit 2: Benchmark annual CLO costs

Source: Amherst Pierpont Securities

• Expected losses of interest and ultimate principal from credit assuming a constant 2% annual default rate and a 60% recovery for the life of the deal.

A detailed example of this simple benchmark suggests that the annual yield on par CLO equity as of March 5 is 13.6% and the compounded annual return on equity after estimated losses is 7.6% (Exhibit 3). It’s worth noting that total debt and equity of $458 million exceeds total assets of $450 million in the example to reflect the common practice of paying for initial deal costs out of funds raised and the impact of discounts on debt sold and the price of assets purchased. These numbers are useful for setting a level at a point in time rather than estimating actual expected return.

Exhibit 3: Example of a point-in-time estimate of return on CLO equity

Source: Amherst Pierpont Securities

A time series of benchmark yields and returns on CLO equity

The estimated 13.6% annual yield and 7.6% compounded annual return on equity start to have value when compared against past levels (Exhibit 4). For example, the series of estimates suggests that potential returns to equity started rising in September last year, peaked as spreads on leveraged loans reached their widest point in late December and recently have started to slowly decline. The latest decline reflects spreads on leveraged loans that have tightened much faster than spreads on CLO debt. Since February 1, for example, benchmark spreads on leveraged loans have tightened 17 bp while benchmark ‘AAA’ debt has tightened only 1 bp. The consequently loss of spread to the equity is reflected in the declining benchmark yield and compounded annual return on equity.

Exhibit 4: Recently tighter benchmark yields and returns on CLO equity still exceed most of 2018’s levels

Source: Amherst Pierpont Securities

The series of benchmark yields and returns also suggest, despite the recent decline, that potential profits to equity are still higher than they were at most points last year. Although this year’s $18.3 billion of CLO issuance is down 14.4% from last year at this time, the slow start likely reflects loan warehouses that built up inventory before spreads on loans and debt widened in late 2018. Current wider spreads on debt require creative solutions, which is why some managers recently have brought deals to market with static pools or short reinvestment periods in hopes of pricing short debt at tighter spreads. However, with incentives to equity still better than most points last year, the CLO bid for leveraged loans and the supply of new debt and equity should start tracking last year’s pace in the months ahead.