By the Numbers
Watch for slow repayments in post-reinvestment 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.
The CLO market has long used a 20% annual repayment rate as a pricing convention but widening loan spreads in the last year have put that in doubt. CLO investors, especially those seeking short ‘AAA’ paper trading below par need to watch extension risk. CLOs do not disclose prepayments. So investors may want to benchmark collateral and bond balances against those they might expect if the 20% repayment rate held true.
Benchmarking class and collateral repayment
A ‘AAA’ CLO bond, which typically represents 63% of the original CLO collateral par balance today, is the first to amortize with loan principal payments in a post-reinvestment CLO. A simple annual repayment rate of 20% assumed in CLO cash flow modeling results in a 20% lower collateral balance than the previous year and a faster ‘AAA’ CLO bond amortization. In five years, a ‘AAA’ CLO principal balance may go to zero (Exhibit 1).
Exhibit 1: A stylized example of collateral and ‘AAA’ CLO amortization
Note: Exhibit above assumes 20% CPR and all principal collections during the post-reinvestment period will be used to amortize the senior most ‘AAA’ bond with no credit risk loan sale and new purchase activity after reinvestment. The tranche thickness of the Class A bond is 63% of the original CLO collateral balance.
Source: Santander US Capital Markets LLC.
The bonds payment window may extend in the post-reinvestment period
Most CLO monthly trustee reports do not differentiate the sources of cash in the cash collection account. The cash can come broadly from two sources:
- Repayment and maturity of portfolio loans
- Proceeds from manager sales of loans
The use of this cash to repay bond principal after the CLO reinvestment period depends on the post-reinvestment language governing manager activity. This language falls broadly in three categories:
- Loose language, allowing the manager wide discretion in reinvesting any cash
- Standard language, allowing the manager to trade only to maintain or improve the quality of the loan portfolio and passing through repayments and maturities to bondholders
- Tight language, allowing the manager limited or no discretion to reinvest
The differences in language have clear implications for the weighted average life of the loan portfolio and CLO debt classes:
- Loose language could delay return of principal especially if the manager chose to reinvest principal repaid through refinancing or maturity
- Standard language should return all repayments and maturities
- Tight language could accelerate return of principal through repayments and maturities and the proceeds of any manager sales
Since most CLOs have standard language, the major driver of collateral and debt class average life is the repayment and maturity of loans. However, investors should be aware of the impact of either loose or tight language.
One straightforward way to see deals and debt classes that stray from a 20% repayment assumption is to benchmark collateral and debt principal factors against a 20% balance. A review of a few CLO deals that have been in the post-reinvestment period for a year or two reveals substantial differences in managers’ activity. The greater the difference between an ‘AAA’ CLO bond factor and the standard 20% would indicate, the slower repayment rates may be (Exhibit 2). For example, based on the date for exiting reinvestment, the outstanding deals managed by CSAM should have a ‘AAA’ bond factor of 0.43. In fact, the CSAM ‘AAA’ classes have a factor of 0.799, likely indicating a much slower pace of loan repayment and maturity—although it is possibly due to loose reinvestment language as well. The difference between benchmark and actual collateral factors also suggest slower repayment and maturity.
Exhibit 2: Managers may invest in loans instead of paying down bonds in post reinvestment period
Note: Exhibit above includes deals with reinvestment periods ended in January 2021 or January 2022. A total of twenty deals included in the analysis. Bond and collateral factors as of March 2023 performance updates.
Source: INTEX, Santander US Capital Markets LLC.
By the end of 2023, nearly 40% of outstanding BSL CLOs will be in the post-reinvestment period. Investors need to closely monitor the principal collection account activity and read the CLO documents carefully. A simple 20% annual repayment assumption may not do the bond valuation job very well for many post-reinvestment period CLOs.
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