The post-reinvestment (post-RI) end date prepayment rates for EU CLOs are significantly lower than those of US BSL CLOs.
In general, lower prepayment rates are not ideal for debt holders, as the collateral notional amounts stay elevated for a longer period of time and thereby expose them to future credit risks and volatility. In today’s market conditions, higher annual prepayment rates are preferable for debt holders, as they facilitate faster deleveraging and quicker paydown of senior debt. Senior holders find this particularly attractive in volatile credit environments, as they can reinvest prepaid cash into more attractive and highly rated assets.
On the other hand, CLO mezzanine tranches are more susceptible to the risk associated with the less creditworthy assets in the underlying portfolio. These assets are typically trading at a deeper discount and hence they will stay behind the portfolio longer, whereas the higher quality assets are likely to be prepaid first. As a result, the success of mezzanine tranches depends heavily on the credit expertise of CLO managers.
That being said, if managers choose to purchase more assets post-RI end date instead of flushing down the waterfall, this would generally not be desirable for mezzanine investors as it would increase their credit risk exposure. Based on a sample of EU CLO deals with RI end dates between July 2019 and December 2021, if EU CLO managers had not purchased any assets post-RI end date, the median prepayment rates (based on the original collateral balance) for the first two years post-RI would be significantly higher than they actually are. In other words, the observed prepayment rates in the sample of EU CLO deals were much lower for the first two years after the RI end date because the CLO managers continued to purchase assets after the RI end date. Additionally, a lower prepayment rate would result in a longer duration, which could amplify any mark-to-market volatility.
Nonetheless, a slow prepayment rate is generally advantageous for CLO equity investors, as it allows for a better cost of funding and a reasonable level of structural leverage for a more extended period. However, equity tranches are the most exposed to the lower-quality part of the portfolio – which boils down to the credit expertise of CLO managers.
In summary, while higher prepayment rates are preferable for debt holders in today’s market conditions, a slower prepayment rate can be advantageous for CLO equity investors, as long as the CLO managers possess the necessary credit expertise to manage the risks associated especially with the lower-quality portion of the portfolio.
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