It is encouraging to witness the year-to-date (YTD) upward trend in collateral floating spreads for EU CLOs in relation to the 2021 vintage deals. The long-term non-recourse funding nature inherent in a CLO structure provides CLO managers with an opportunity to navigate challenging environments and bolster their net interest margins during periods of volatility. On average, the US BSL CLOs (2021 vintage deals) have only demonstrated a marginal improvement of around 4.5 basis points (bp) in the year-to-date collateral weighted average spreads across the deals (before making any adjustment to the basis due to different interest rate reference rates).
Enhancing the average collateral spread of a CLO portfolio is no simple undertaking. Let us consider an illustrative example: if a specific A&E loan, constituting 1% of the overall portfolio, were to witness a significant 100 basis point increase in its spread, the subsequent impact on the portfolio would amount to a mere 1 basis point increment — fairly inconsequential. Therefore, achieving meaningful results necessitates both time and ‘favourable’ market conditions.
From an equity perspective, the trend in net interest margin (the underlying collateral weighted average spread net of the cost of funding) plays a crucial role in generating the necessary net interest income to potentially offset future collateral losses resulting from defaults or trading. Given the leverage involved in the CLO structure, collateral losses have a disproportionate impact on equity NAV metrics.
While the current CLO equity NAV metrics are unsatisfactory, they do not necessarily indicate that the eventual final equity NAV metrics will be poor. However, for seasoned CLO deals that are ripe for redemption, these low equity NAV metrics are less than ideal. A respectable final NAV becomes highly crucial if the average equity annual distribution of a CLO deal typically ranges from 12–14 percentage points (as a percentage of par). Conversely, if the average equity annual distribution is favourable due to a healthy and improving net interest margin over the lifespan of a regular CLO deal, the heavy reliance on the final equity NAV to achieve a double-digit IRR is diminished.
Upon analysing the seasoned CLO deals that were redeemed this year, it becomes evident that the final equity IRRs of these deals would have been more favourable if they had been called in 2021. Emphasising the importance of achieving a healthy final equity NAV is crucial, as future annual distributions may not adequately offset a decline in the final NAV.
It is noteworthy that the majority equity investors were responsible for making those calls (unless the CLO manager was the first-loss retention holder). Consequently, it can be unfair to evaluate a manager solely based on their CLO equity IRRs. The performance of CLO equity IRRs is influenced by various factors, including underlying collateral performance (including market value and interest components), cost of funding, management fees, upfront and ongoing costs, leverage structure, and timing of the call.
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.
