Collateralised loan obligations (CLOs) are a type of securitised product in which CLO managers purchase a portfolio of corporate leveraged loans, funded by CLO bonds sold to investors. CLOs are a significant source of capital for leveraged loan borrowers, accounting for 60-70% of the loan investor base.
CLOs are created with an initial 4-5 year reinvestment period; during that time the CLO manager can keep reinvesting principal repayments into new loans for the portfolio. Once this period ends, reinvestment constraints tighten significantly, with principal repayments used instead to repay the CLO bonds.
Since the Global Financial Crisis, CLO managers have been able to repeatedly refinance and extend their reinvestment periods, maintaining reinvestment flexibility. However, today’s less accommodative market backdrop has made CLO refinancing/reset transactions uneconomical, and as the chart shows, the proportion of CLOs exiting their reinvestment periods has soared.
This loss of CLO purchasing power has negative implications for leveraged loan demand as a whole and potentially forces companies that use this market as a source of finance to find other pockets of liquidity (e.g., high yield or private credit). However, we think some segments of both CLO and loan markets should benefit from the trend.
Firstly, high-quality, short-dated loans are likely to remain well supported. The most restrictive reinvestment constraint once a CLO exits its reinvestment period is usually the ‘Weighted Average Life Test’, a test which tends to push CLO managers towards buying shorter maturity loans.
Secondly, reinvestment constraints are forcing CLO managers to return more cash to their CLO bond investors. This should be supportive of valuations of short-maturity CLO bonds, a significant proportion of which still trade at a discount to par.
So while funding conditions have become more difficult for the corporate borrowers underlying the CLO and leveraged loan markets, we think there are strong technical factors supporting the shorter end of each market. This creates opportunities for managers with access to these more specialised areas of the global credit market.
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