“When you are in need of something, you must also give this something to others.”
CLO Research: Year-End Review (Updated)
In the US CLO market, the size of managers plays a role, with larger, seasoned managers generally outperforming their smaller counterparts. This observation is based on a sample of seasoned deals from 2015 to 2019. However, it’s important to note that this trend is not universally applicable, as variations in performance are observed among both large and small managers.
In contrast, in the European CLO market, the size of managers does not appear to be a decisive factor in asset outperformance. Recent analysis of deal performance, particularly of the 2021 vintage, indicates that small European CLO managers are significantly represented in the top quartile, as assessed by their annualized alpha performance since inception. Notably, 50% of these high-performing managers oversee EU CLO assets ranging between EUR 1.0 billion and EUR 2.0 billion (as of 30 September 2023). However, it is equally important to recognize that small managers constitute a third of the managers in the lowest quartile. Despite this, small managers—those managing EUR 1.0 to 2.0 billion in EU AUM—have, on average, demonstrated commendable performance when compared with their larger counterparts in the EU CLO market.
Record US CLO issuances appear to correlate with a decrease in OC Test cushions for the respective vintages, as observed in 2014, 2018, and potentially 2021. Notably, in the US CLO market, 2014 was a record year for issuances, a record which was surpassed in 2018 and again in 2021. The median US CLO deals from the 2014 and 2018 vintages exhibit concerning test cushions of approximately 0.6 points and 1.6 points, respectively, indicating a significant erosion of principal value. On the other hand, across the pond, the minimum OC test cushions for EU CLOs from the 2014 and 2018 vintages look much better, at around 3.6 points and 3.5 points, respectively. In the EU CLO market, 2021 was a record-breaking year for EU CLO issuance. Does this indicate that the 2021 vintage may potentially underperform in due course? Currently, various market value metrics uniformly indicate a pessimistic outlook for the 2021 vintage deals. In light of these challenges, the selection of the right manager becomes even more crucial.
In terms of static US CLO equity performance, redeemed deals have generally demonstrated favorable outcomes on average. This success can be attributed to a combination of factors, including good collateral performance, higher leverage within the capital structure, and reduced management fees.
Seasoned US CLO managers have demonstrated a notable capability in delivering value to their investors. On average, they have surpassed the loan index by approximately 5 basis points (bps). However, this average outperformance is lower than the management fees typically charged by CLO managers.
European CLO equity, on an average, has outperformed its U.S. counterpart based on fully redeemed 2.0 deals to date. The Internal Rate of Return (IRR) performance of a CLO equity tranche is influenced by several elements, including the performance of the underlying collateral since inception, cost of funding over the deal’s lifespan, management fees, upfront costs, the leverage of the CLO structure, and the timing of the deal’s redemption. For instance, certain seasoned European CLO deals would have achieved a higher final equity IRR if redeemed in 2021.
Reset deals typically yield positive results for equity investors. If a deal continues to pay equity distributions over an extended period, the final equity IRR becomes less reliant on the final equity Net Asset Value (NAV). This factor is particularly significant in the performance of 2.0 CLO equity.
The reason 1.0 US CLO equity (2006-2007) was not dependent on the final equity NAV is that its median annual distribution was consistently strong, close to 20%, over a long period. The likelihood of 2.0 CLO equity replicating these high annual distribution rates, as observed in the earlier period, seems very much significantly reduced. This reduction is primarily due to the absence of several key factors that were instrumental in driving the high performance levels of 1.0 equity. Such a paradigm shift necessitates a recalibration of expectations and strategies within the current 2.0 CLO market context.
Post-reinvestment prepayment rates show notable variations among deals, with the first two years after reinvestment being particularly critical.
Primary CLO debt tranches are often modelled with an overly conservative approach in terms of duration. An analysis of 500 redeemed deals indicated that they were usually called when their collateral pool factor had reduced to approximately 78%. This observation raises questions about the potential overcompensation of debt tranches at the expense of equity investors.
U.S. CLO managers with minimal CCC buckets typically perform well. However, those with CCC buckets in the 6-9% range show inconsistent alpha performance.
The Weighted Average Spread (WAS) is often considered a measure of portfolio risk. Managers with a conservative portfolio, as indicated by their WAS, tend to secure tighter liability prints. While these managers showed stronger performance in 2020, it is noteworthy that managers with both wide and tight WAS metrics have demonstrated comparable Market Value (MV) return alpha performance metrics since late 2020.
The Morningstar Indexes are the exclusive property of Morningstar, Inc. Morningstar, Inc., its affiliates and subsidiaries, its direct and indirect information providers and any other third party involved in, or related to, compiling, computing or creating any Morningstar Index (collectively, “Morningstar Parties”) do not guarantee the accuracy, completeness and/or timeliness of the Morningstar Indexes or any data included therein and shall have no liability for any errors, omissions, or interruptions therein. None of the Morningstar Parties make any representation or warranty, express or implied, as to the results to be obtained from the use of the Morningstar Indexes or any data included therein.
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 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.