CLOs Adapt to New COVID-19 Reality

In a previous blog we wrote about the drought in the ABS primary market during the lockdown period, in comparison to the very active corporate and covered bond markets.

After six weeks of no supply, the market somewhat surprisingly reopened with three new issue CLOs being priced last week and a new one already on the way. We are aware of many loan warehouses that need to be cleared, and bankers (or rather their risk managers) are no doubt keen for CLO managers to refinance leveraged loans into a CLO.

We understand the three prints, from Permira, Redding Ridge (Apollo) and KKR, were all ‘club deals’ placed to very few investors. As expected, they look very different compared to traditional CLOs and we noticed some common features that are worth mentioning. The deals were smaller in size and shorter, with six to 12 months of non-call period and a shorter reinvestment period of 1-3 years, compared to the typical 4.5 years. Most of the tranches were issued at a discount, even at the investment grade level. From an investor point of view this so-called “pull to par” feature can add a lot of value, especially combined with a shorter non-call period when holders can be repaid at par at the time of a refinancing, but it may also be the only way managers can make their CLO cash flows work as funding still looks very expensive.

Another difference is lower than typical leverage, resulting in higher credit support for the rated bonds sitting above the equity. The new structures mostly consist of only four debt tranches rated from AAA to BBB, which is understandable given the significant widening in sub-investment grade liability spreads. Equity buckets represent 13-15% of these deals versus around 8-10% for pre-virus transactions, making the overall leverage substantially lower. This manifests in higher protection for bondholders against losses, but also in more conservative covenants to tackle corporate downgrades. According to an April report from S&P titled ‘Redesigning the CLO blueprint after COVID-19’, new deals’ ratings are being assessed assuming a higher level of default rates than those indicated by the portfolios’ current credit quality, therefore adding more headroom to accommodate potential future credit deterioration. While this would seem prudent, we would note that old deals were also said to be rated “through the cycle”.

On the documentation side, in one deal we noticed stricter covenants to manage any principal leakage; CLO debt investors of course don’t like to see any extra protection built through discounted assets leaving the transaction and getting into the equity investor’s pocket, and we expect this to be a welcome trend for future deals.

During the COVID-19 sell-off CLO spreads widened much quicker and more steeply than leveraged loans on the whole, increasing the overall cost of debt for transactions on average to around 250bp over Euribor, versus 180bp in February. With warehoused loan spreads mostly held in the 350bp-400bp area, the structures we have seen in primary are probably the best option an equity investor has to recover any value lost in the pre-virus warehouses, and for banks to get loans off their balance sheets (the banks are also probably happy to negotiate around absorbing the cost).

KKR however is the exception. We understand this deal didn’t come from a pre-existent warehouse but was put together in a few days following a reverse enquiry from the equity investor, who we believe also bought the junior mezzanine tranches. This is an example of what is often referred to as a “print and sprint” CLO, where the manager locks in the liabilities and uses the proceeds to purchase the loans quickly and at cheap levels, such as those around in March and April.

Despite the investor base in the new issues likely being limited, we consider the revival in CLO primary activity positive for the market. As experienced in 2008/2009, static or shorter CLOs were used for some time before a standard structure was developed. The rules for a post-virus standard structure – CLO 3.0? – are yet to be set, and until the market environment stabilises we welcome seeing clean structures coming to the market and  giving guidance for future pricing.