The typical structure of a collateralized loan obligation (CLO) offers two years of call protection from the time of issuance. Once that call protection period has expired, the callability of the CLO becomes a free option to the CLO equity holder. Even under normal market conditions, predicting the timing of CLO redemptions is tricky at best. However, the ability to accurately estimate the likelihood and timing of CLO redemptions remains an important element of alpha generation in the sector and is worthy of any CLO analyst’s consideration.
There are three main types of CLO refinancing. A reset includes a reduction to the cost of liabilities, extends the period during which the CLO manager may reinvest the pool of assets and adds some call protection. A straight refinancing typically includes a reduction to the cost of liabilities and may include some additional call protection. A reissue is similar to a straight call, but the collateral is largely rolled into a new structure, maintaining virtually the same collateral profile while resetting the cost of liabilities, the reinvestment period and the non-call period. All three types may include changes to deal documentation as well.
This week’s chart compares historical CLO refinancing volume over the past few years to average AAA coupon moneyness — a measure of how much the average AAA CLO coupon can be reduced at current spreads. Most CLO equity holders will not refinance a deal unless the AAA coupon can be materially reduced. The chart shows a strong correlation, as expected, between CLO refinancing activity and how in the money the AAA coupon is, on average. When moneyness is strong, refinancing issuance is heavy. When moneyness is close to zero, refinancing issuance is reduced. When moneyness is deeply out of the money, as we saw during the second quarter this year, CLO refinancing issuance can come to a standstill. There is also a vintage effect in refinancing attractiveness. Since the typical CLO structure has a two-year non-call period, the moneyness at a given point in time can be approximated by comparing market issuance spreads at that time to average AAA CLO coupons two years prior to that time. Even though AAA coupon moneyness hasn’t been that attractive during the fourth quarter, spreads have tightened tremendously over the quarter, enabling a spurt of refinancing activity ahead of the holidays. Additionally, a number of deals were issued this year at wider spreads and with only one year of call protection. If spreads stay as tight as they are now or go tighter, we’re likely to see a rebound in refinancing activity in 2021 as deals issued in 2019 and 2020 become callable.
Key Takeaway
Predicting the likelihood and timing of CLO refinancing activity can be an important source of alpha in CLO investments. CLO refinancing volume is highly correlated with how in the money the AAA coupon of the CLO is. Vintage coupon analysis combined with an accurate understanding of current market spreads and a sophisticated view of where spreads are headed can inform investors about the likelihood of imminent CLO refinancing activity.
The material provided here 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 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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