February pull-back widens the entry point for fixed income
European CLO new issues have picked up in 2023 to €5.5bn of issuance YTD as CLO managers are using the current window of relative market stability to price their deals. This is despite the low supply of leveraged loans (consisting mostly of maturity extension of existing loans) and the difficult arbitrage, given we’re seeing AAA new issue spreads coming at 3m Euribor+ 175bps. It is however worth noting that this is still significantly wider than historic tights.
Since last year’s issuance, we have seen the mezzanine and junior CLO investor base evolving with a material uptick in hedge funds (including US buyers). While hedge funds and private equity provided a great source of liquidity during the LDI selling late in 2022, they are investors that typically buy assets they think are fundamentally cheap and don’t typically hold them to maturity meaning they are generally less demanding on documentation for CLOs. On the flip side, the resurgence of Japanese investors anchoring AAAs in new issue CLOs has led to tighter documentation, albeit with their requirements more focused on AAA noteholders rather than all bondholders’ interests. This has left asset managers and other more traditional holders, in a tricky situation as it makes it more difficult for them to negotiate tighter documentation. Given we think we’re approaching, if not already in, a late cycle environment, we have become more defensive and have required tighter documentation, with an increased focus on providing important downside protection against credit and extension risk of CLOs.
Over the past few years, it has become clear that CLO managers and equity holders were willing to leave their deals outstanding as long as they could to maximise equity returns rather than refinancing into more expensive capital structures. A CLO typically has a reinvestment period of 4.5 years, after which the CLO manager has to satisfy specific covenants in order to continue reinvesting “unscheduled repayments”. CLO managers have then used the flexibility given to them through these covenants to continue reinvesting and extend the life of the CLOs, by 1 year in some cases. As a result, there is a growing proportion of around 25% of CLOs outstanding that are past their reinvestment period and this is expected to double by the end of 2024, assuming CLO managers don’t call or refinance these deals. In addition, on certain occasions in 2021, we voiced our concerns to CLO managers that we thought they were abusing documentation to make amendments to these reinvestment covenants, for example by offering a waiver fee to the AAA noteholders to get their approval thereby going against mezzanine holders’ interest and creating extension risk for bond holders. As a consequence, over the past two years wherever we are looking to invest into CLO new issues we now request additional rights, making sure these are built into the documentation itself and we are pleased to say that this is now becoming standard market practice. While we understand it makes an economic sense to equity holders and managers to keep CLOs outstanding, as investors we would prefer the CLOs to start amortising naturally over time after the end of the reinvestment period.
Having said that, in recent weeks, we have seen some positive development and one of the better prints was the 15th (post GFC) CLO from ICG, done by JPM. After receiving investor feedback over a number of their newest CLOs, ICG included much stricter covenants, to access capital from longer term investors in their new issue. In addition to the requirement of mezzanine investors consent (as opposed to just that of the AAA holders) to make any amendments to the documentation, there are stricter covenants in place for reinvesting and further hard limitations on the types of reinvestments that can be made 12 months after the end of the reinvestment period, meaning only those that aim to improve the quality of the assets in the CLOs can be targeted by the manager (rather than just to reinvest any prepayment or sale proceeds). We think this is a very positive development for mezzanine debt investors as it looks to ensure CLOs have a finite life and essentially forcing the CLOs to amortise quicker through the tighter documentation. In this case the ICG bonds offer a new issue yield to maturity of 9.5% and 12.7% in euros for BBBs and BBs respectively, and leaving a decent call-optionality for BBs on the table as they priced at a cash price of 92.
We think this is great governance and a really positive development and speaks for ICG’s longer term commitment to all investors. And we encourage other managers to follow their example and hope that all debt investors maintain a firm stance on documentation. While it’s easy to be blinded by the yield on offer we also have to be realistic that we look to be at the end of an economic cycle and we’ll need the documentation to be our first layer of protection.