June 2017 has been a banner month for the new issue of collateralized loan obligations (CLO) when including all three new issue types of regular way, resets, and refinancings. Month-to-date there have been 30 regular way, 20 reset and 19 refinancing deals marketed by the Street, totaling $34 billion across 69 deals. Based on our observations, Citi, Jefferies and Bank of America Merrill Lynch have led the league table in marketed deals for the month, and investor demand in the space continues to be healthy.
A CLO reset is when the manager and equityholder decide to reduce the cost of the liabilities in the deal while simultaneously extending the reinvestment period. A CLO refinancing is when they reduce the cost of the liabilities but leave the existing reinvestment period intact. In recent years, a four-year reinvestment period has become somewhat standard. However, there has been a recent push by CLO managers and equityholders to extend reinvestment periods to five years in regular way and reset new issue deals. A longer reinvestment period gives the CLO manager and equityholder an option on volatility and more flexibility to generate alpha, as well as the opportunity for the CLO manager to lock in fees for a longer period of time. In general, debt investors are typically compensated appropriately when taking on a longer spread duration. However, that doesn’t seem to be the case lately with CLO new issue. Adverse selection has come into play, where the stronger managers have been successful in printing deals with five-year reinvestment periods, while managers with weaker liquidity have been forced to stick with the four-year reinvestment period model. With this adverse selection in mind, this week’s chart shows that investors care more about the strength of the manager than they do about the length of the reinvestment period. This dynamic has led to a situation where the deals with five-year reinvestment periods print at tighter spreads on average than the deals with four-year reinvestment periods.
This dichotomy of manager quality presents an opportunity for debt investors who are willing to roll up their sleeves and perform their own due diligence on CLO managers. Street research offers periodic manager rankings, but investors should decide on their own which factors matter most to them in determining how ‘debt-friendly’ a manager is. One of the first things investors can learn by doing this sort of analysis is there is a lag between liquidity and quantitative performance from a debtholder’s perspective. What if you could invest in a deal that has both a manager with top-tier quantitative performance in their post-crisis deals and also a four-year reinvestment period? According to our analysis, four of the 69 deals marketed in June have demonstrated this ‘unicorn’ profile and have provided good relative value in a crowded new issue space.
Key Takeaway:
CLO new issue was strong in June 2017 among the three new issue types: regular way, resets, and refinancings. Regular way and reset CLOs offer the CLO manager the opportunity to set or reset the length of their reinvestment period. There has been a recent push by CLO managers and equityholders to extend these reinvestment periods to five years instead of the four-year period that has been in vogue in recent years. A longer reinvestment period is more favorable to equityholders at the expense of the debtholders. Managers that are perceived as top-tier and who have the best liquidity have been the most successful in extending their reinvestment periods to five years. A small handful of deals have provided both a strong manager and the shorter, four-year reinvestment period, which has proven to be a unique relative value opportunity.
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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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