“Never confuse motion with action.”― Benjamin Franklin.
Thoughts On CLO Arbitrage — Safety Margin
How much net collateral interest margin is needed for CLO equity arbitrage?
Net collateral interest margin means the CLO portfolio annualised interest return net of running costs of funding, including management fees, since inception. Based on the historical investment performance data CLO Research has observed so far, 180bp appears to be a good starting point.
Upfront costs relating to primary issuance, as well as refinancing or reset expenses, are not included. Without taking into consideration management fees, the net collateral interest margin would be at around 230bp. This is perhaps about 30bp higher than what the market thinks.
At the actual realised long-term net collateral margin of around 190bp (net of management fee too), EU CLO Equity (closed in 2014) did what they were supposed to do, especially in the top-tier group.
As management fees are applied to the entire collateral pool, the added running cost to the liability funding cost will be higher than the actual headline fee implies (given that the collateral pool notional is higher than the sum of liabilities). If deals saw a net interest margin of less than 180bp, they might not have enough cushion to absorb any collateral MV deterioration. A portfolio would inevitably suffer from some credit losses due to trading and default over the life of a deal.
As CLOs are managed vehicles, managers do churn the portfolio. Besides, a CLO would normally be redeemed before its legal maturity date, so paper portfolio losses would be materialised upon redemption at some point.
So far, EU CLOs tend to see better investment performance on the interest return and MV fronts.
CLO Research believes that US CLO deals need to see much tighter liability prints (and a longer reinvestment period of over 5 years). Reaching for higher-yielding assets might come at a cost, but some managers seemed to be better at navigating the credit landscape than others. As long as the primary CLO supply remains elevated, the journey towards a much tighter CLO print that will give a certain safety margin might prove to be quite challenging. Perhaps it is time for CLO equity investors to be more disciplined?
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