Investing in discounted BB-rated CLO tranches can yield significant rewards in the following scenarios:
Market Momentum: In times of a robust rally in the loan market, CLO tranches, especially the mezzanine tranches, stand to deliver a robust performance. Exposure to mezzanine CLOs can be seen as a leveraged bet on the loan market’s performance. As a result, having a good understanding of the loan market’s trajectory is beneficial.
Accelerated Prepayments: Rapid prepayment rates, especially during the initial one to two years following the reinvestment end-date, lead to a substantially reduced leveraged structure within the CLO. This, coupled with an elevated cost of funding as the AAA tranche is retired first, significantly enhances the likelihood of full redemption by equity holders.
Strategic Equity Ownership: When a majority equity holder holds a significant stake in discounted CLO debt within the same transaction, opting to call the deal can offer greater advantages. In other words, the total proceeds realised from calling the deal far surpass the total proceeds generated by selling the CLO equity and debt tranches.
Opportunity Costs: Typically, deals are called or reset during periods of strength in the loan market. However, it’s worth noting that quite a few seasoned deals were redeemed this year. It’s likely that the majority equity holders considered the potential future equity distributions to be insufficient to justify the associated risks arising from future equity NAV volatility.
What Risks Should You Consider?
Investors must exercise caution as some BB tranches trade at substantial discounts for valid reasons. For example, if a deal’s underlying collateral has experienced significant principal value erosion, it can become challenging for the collateral value to sufficiently cover all CLO liabilities, potentially transforming these deals into ‘zombie deals.’
MTM Risk: Keep in mind that exposure to lower-mezzanine CLOs can be considered a leveraged bet on the performance of the loan market. In other words, investors should be mindful of the MTM volatility.
Related articles:
Seasoned US BSL CLOs: Post-Reinvestment-Period Annual Prepayment Rates Vary
US MM CLOs: Post-Reinvestment-Period Annual Prepayment Rates
2022 US BSL CLO Deals: Reset Candidates (Updated)
2022 EU CLO Deals: Reset Candidates (Updated)
EU CLOs: Post Reinvestment Period Annual Prepayment Rates
Disclaimers
The information, research, data, research-related opinions, observations, and estimates contained in this document have been compiled or arrived at by CLO Research Group, based upon sources believed to be reliable and accurate, and in good faith, but in each case without further investigation. None of CLO Research Group or its service providers; authorised personnel, or their directors make any expressed or implied presentation or warranty, nor do any of such persons accept any responsibility or liability as to the accuracy, timeliness, completeness, or correctness of such sources and the information, research, data, research related opinions, observations and estimates contained in this document. All information, research, data, research-related opinions, observations, and estimates in this document are in draft form as of the date of this document and remain subject to change and amendment without notice. Neither CLO Research Group nor any of their third-party providers shall be subject to any damages or liability for any errors, omissions, incompleteness, or incorrectness of this document. This article is not and should not be construed as an offer, or a solicitation of an offer, to buy or sell securities and shall not be relied upon as a promise or representation regarding the historical or current position or performance of any of the deals or issues mentioned in it.
