By the Numbers
The rise of refi risk in CLOs
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.
Wide CLO spreads through most of last year and tight spreads currently have set up 2021 as a year for heavy refinancing of CLO debt. Not all managers face the same opportunity, however, since the debt of different managers trades at different spreads even for the same rating. But after adjusting for the spread of each manager to the market average, more than $113.6 billion in ‘AAA’ CLO debt looks refinanceable this year with billions more in lower rated classes.
A roundtrip in spreads
CLO spreads have made a dramatic roundtrip over the last 12 months. CLO ‘AAA’ spreads widened above 320 bp in late March before falling back to 120 bp in December. Similarly, CLO ‘AA’ and ‘A’ spreads more than doubled at the height of the coronavirus pandemic to 430 bp and 530 bp, respectively, before returning to their pre-COVID levels. Meanwhile, CLO ‘BBB’ and ‘BB’ spreads also widened in March and then gradually drifted back toward their pre-pandemic levels of 350 bp and 650 bp, respectively.
At current spreads, CLO equity holders have incentives to call classes that have come out of their non-call period and can get refinanced or restructured at a lower cost of funds. Managers that can lower liability costs help improve residual cash flows to equity. For investors in the debt, of course, the risk of having the debt called limits its price appreciation above par, making the debt negatively convex to spreads.
Exhibit 1: CLO spreads tightened back to levels a year ago after spiking up in March
Sources: APS, Bloomberg, Palmer Square
Spread distinctions between managers
These spreads nevertheless track averages, and those averages hide a dispersion in spreads at new issue. In October, for example, the month last year with the heaviest CLO issuance, 42 deals came to market at different spreads. The average ‘AAA’ class came to market at 141 bp but with a wide distribution (Exhibit 2). Some traded as tight as 127 bp and some as wide as 165 bp.
Exhibit 2: CLO ‘AAA’ spreads show dispersion at issuance in October 2020
Sources: APS. Only discount margins recorded for floating-rate CLO deals issued in October 2020 are included for this histogram.
The difference in spread reflects a range of factors commonly associated with particular managers. That includes the volume and liquidity of outstanding deals, the type of leveraged loan collateral the manager tends to favor, the managers trading strategy, the institutional strength of the managers and other considerations. These factors tend to persist over time, allowing managers to come to market consistently wide or tight to the average.
In fact, CLO debt brought to market in October at each rating category had an average spread and a dispersion (Exhibit 3). While ‘AAA’ debt in October issued at an average spread of 141 bp with a standard deviation of 10 bp, ‘BB’ debt, at the other extreme came at an average spread of 815 bp with a standard deviation of 58 bp.
Exhibit 3: Average and volatility of CLO primary spreads rise down the capital stack
Sources: APS. Only discount margins recorded for floating-rate CLO deals issued in October 2020 are included for this table.
Not all managers refinance at the same spread
Not all managers have an equal shot at refinancing. Managers that trade tight to market averages may have an even better opportunity to refinance and managers that trade wide may have poorer prospects. It is important to adjust average market new issue spreads for managers’ historical dispersion.
For example, the average new issue ‘AAA’ comes to market currently around 3-month LIBOR + 125 bp. A manager that historically trades one standard deviation above the average could potentially refinance at 3-month LIBOR + 125 bp + 10 bp, or a spread of 135 bp. A manager that historically trades one standard deviation tight could potentially refinance at 3-month LIBOR + 125 bp – 10 bp, or a spread of 115 bp.
Amherst Pierpont tracks the monthly historical spread dispersion of all CLO debt issued back to 2005. The nominal spread on each CUSIP gets converted into a Z-score for its rating category in that month, representing standard deviations above or below the average in a given month. Each manager gets a Z-score in each rating category, weighted by the historical par amount of debt issued in each category.
The impact of managers’ historical spread shows the impact on refinancing opportunity. For all ‘AAA’ CLO debt outstanding as of January 1 and existing its non-call period at some point in 2021, comparing the debt margin to a refinancing margin of 125 bp shows that $126.5 billion is refinanceable (Exhibit 4, Method #1). However, comparing the debt margin to a refinancing market of 125 bp and adjusted for the managers’ Z-scores shows that $113.6 billion is refinanceable (Exhibit 4, Method #2).
Exhibit 4: A third of CLO ‘AAA’ universe seems refinanceable after adjusting for the managers’ Z-scores
Sources: APS, Intex, Bloomberg. Eligible universe is defined as all CLOs that are outstanding as of January 1, 2021 and will exit their non-call period by December 31, 2021. Total amount represents the sum of the par balance of applicable deals.
A table of refi risk and opportunity
The picture of opportunity to refinance debt at different rating levels varies significantly across managers. Taking ‘AAA’ debt for example, Elmwood has 100% of its callable ‘AAA’ debt potentially refinanceable in 2021 at current market levels (Exhibit 5). Alcentra has 0% of its callable ‘AAA’ debt potentially refinanceable. At the other end of the rating spectrum, Whitebox may have 100% of its callable ‘BB’ debt in the money to refinance, while Goldentree may find 100% of its callable ‘BB’ debt out-of-the-money to refinance.
Opportunity for equity represents risk for investors that hold the debt above par. The risk and the negative convexity vary significantly across managers. And investors in CLOs this year need to keep a close eye on each position, the coupon and current new issue levels—adjusted for the tendency of the manager to trade wide or tight to market averages.
Exhibit 5: CLO managers have different shares of their debt refinanceable by rating class
Sources: APS, Intex, Bloomberg. Note: Eligible universe is defined as all CLOs that are outstanding as of January 1, 2021 and will exit their non-call period by December 31, 2021.
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