A type of refinancing transaction is becoming more popular in the $1.3 trillion market for collateralized loan obligations, a sign the industry is healing as concerns over surging inflation and a potential recession abate.
Known as resets, these transactions can extend the life of CLOs for years. In the past they’ve made up as much as a third of annual issuance, according to data compiled by Bloomberg. But last year’s sharp deterioration in credit conditions all but put the deals on ice.
Now, they’re making a comeback. Credit Suisse Asset Management and Oak Hill Advisors have in recent weeks reset liabilities for CLOs that were originally issued during the second half of 2022. Resetting allows the CLOs to essentially cut the costs at which they borrow. That translates to more money leftover for the holders of the riskiest and highest-returning part of the structure, the equity portion, after other note holders have been paid.
Bank of America Corp. says there’s around $20 billion of additional CLOs that were issued around the same time — when funding costs reached multiyear highs — that could be reset in the coming months.
CLOs sold in the second half of 2022 that can now be called “are ripe for a reset, as liabilities were extremely wide back then,” said Meric Topbas, head of structuring at CSAM’s credit investments group. There were more than 70 such deals over the span, and more than half priced their AAA bonds at a spread of over 2 percentage points, he said, compared with as low as 1.75 percentage points at present.
Refinancings and resets for CLOs, which package and sell leveraged loans into chunks of varying risk and return, aren’t that different from those for traditional fixed-income securities.
In refinancings, CLOs are called by the equity holders — who have control over the structure as compensation for being last in line to receive cash flows from the underlying loans — and reissued via lower cost debt, denting payouts for bond holders higher in the capital stack and boosting equity returns.
In a reset, the CLO is refinanced, the maturity of the debt is extended and the deal size is sometimes tweaked. If CLO bond holders choose not to participate, new investors are typically brought in.
CSAM last month successfully completed a reset that extended a $396 million CLO initially priced in July of last year. Oak Hill also wrapped up a reset of an upsized $567 million CLO last month, extending a deal originally issued in June of 2022.
“We tightened the liabilities and increased the total size of the CLO without injecting additional equity,” said TK Narayan, portfolio manager and partner at Oak Hill. “We expect to see more resets, so long as they improve the returns for equity holders.”
Bank of America’s Pratik Gupta agrees. His team of analysts predicts that refinancings and resets for US CLOs will increase in the near term, and estimate the total volume of potential deals, based on their call periods and spreads, to be close to $20 billion.
The reemergence of resets underscores the extent to which credit conditions have improved in recent months.
CSAM’s original transaction had priced the AAA rated tranche at 2.25 percentage points, while the reset came at 1.85 percentage points, some 0.4 percentage point tighter. Some collateral managers priced AAA bonds at spreads as wide as 2.6 percentage points last year.
But more reset deals will also add supply to a market that’s struggled to attract enough investors. US banks in particular, once the biggest buyers of AAA tranches, have mostly stayed on the sidelines in recent months amid a decline in deposits and expectations for increased capital requirements.
And Japan’s Norinchukin Bank, once one of the world’s biggest buyers, has said it plans to keep CLO holdings around current levels.
Of course, the universe of potential refinancings is just a fraction of the total market, and the vast majority of CLOs have little incentive to reset at present, market watchers say.
For more, subscribe to the Structured Finance Weekly
Resets are also expected in Europe, though later in the year given 2022 deals from the region often had longer periods in which the debt can’t be called.
BofA European CLO strategist Dustin Walpert said in an interview that about an estimated €3 billion ($3.3 billion) of CLOs should be ripe for resets.
“In Europe we’re not expecting to see refis or resets happen until the third or fourth quarter this year,” Walpert said. “There are only a few deals that both issued at very wide spreads last year and are exiting their non-call period later this year.”
--With assistance from Eleanor Duncan and Charles Williams.
