Tightening Spreads Show How Expiring CLO Debt Non-Call Periods Can Benefit CLO Equity Investors

• CLOs have the option to refinance their CLO debt after their non-call periods expire, and those that can do so at today’s lower market rates may strengthen future distributions to equity holders without adding to portfolio credit risk.

• On average, 2022 and 2023 vintage CLOs were issued with shorter non-call periods, many of which will expire in the coming quarters, so the number of reset/refi candidates is set to increase as CLO spreads tighten and non-call periods run off.

• We believe managers with strong credit performance and who actively evaluate CLO market opportunities will be best able to provide better economics for equity investors as new CLO debt is issued at today’s lower market spreads.

On average, 2022 and 2023 vintage CLOs were issued with shorter non-call periods, many of which will expire in the coming quarters – and this could be good news for CLO equity holders.

CLOs can be refinanced at lower debt costs in today’s market

Similar to refinancing a mortgage when rates are lower, the end of the non-call period provides a CLO the opportunity to refinance its debt to current market rates, which are the lowest they have been since 2021 (see chart).

CLOs Can Refinance Debt at Today’s Lower Rates Once the Non-Call Period Expires

Source: LCD, Bloomberg, Palmer Square, PSL (Prytania), Barclays data as of 30 June 2024. WACC: weighted average cost of capital. The WACC calculation assumes a typical capital stack with credit enhancements as follows: AAA, 37%; AA, 24%; A, 18%; BBB, 12%; BB, 8.5%. Assuming the above, weight the tranche-specific DMs with the corresponding tranche thickness (e.g., AAA DM weighted by 63%, AA DM weighted by 13%, etc.) to arrive at the WACC. DMs derived from the Palmer Square indices. The margin calculation assumes a 70%/30% blend of B/BB nominal loan spreads sourced from LCD.

While two-year non-call periods are the most common length for recent new-issue CLOs, many CLOs were issued with shorter non-call periods during 2022 and 2023, when CLO liability costs were high relative to historical levels (see chart). The net spread between high CLO debt spreads and nominal loan spreads made the cash arbitrage less attractive, as shown in the first chart above. The fourth quarter of 2022 was the only quarter across 2022 and 2023 in which less than half of new-issue CLOs had debt non-call periods of two years or longer.

CLOs Issued With High WACC (Relative to Historical Averages) Often Carry Shorter Non-Call Periods

AAA primary spreads used as proxy for WACC

Source: CLO Global Databank from Pitchbook LCD as of 5 July 2024 and Bank of America Weekly AAA Primary Spreads as of 28 June 2024. WACC: weighted average cost of capital. Note: The chart focuses on new-issue US CLOs that priced during the past 10 full quarters, starting with 1Q22. We exclude refinancing and reset CLOs, which were not an active part of the market during 2022 and 2023. For example, US CLO reset activity was only $39.6 billion during 1Q22 through 4Q23 and compares with US CLO new-issuance volumes of $244.8 billion during the same period.

Lower CLO debt costs can strengthen distributions for equity holders

As market spreads normalized during 2024, CLO liability spreads have compressed. All CLO portfolios are facing tighter loan spreads given strong loan technicals and elevated loan repricing activity. However, CLOs issued during 2022 and 2023, particularly CLOs with strong credit performance, will be well positioned to refinance their CLO debt at today’s lower market rates, strengthening future equity distributions without adding to portfolio credit risk. A CLO refinancing is a reduction of a CLO’s debt costs with no change to the CLO’s debt maturity profile. In contrast, a CLO reset is a refinancing of all outstanding CLO debt and an extension of the CLO’s maturity. Through the extension of the reinvestment period, reset transactions provide more time for a CLO manager to generate strong equity distributions and potentially take advantage of market volatility. The number of reset/refi candidates will only increase as CLO spreads tighten and more non-call periods run off.

Managers with strong credit performance are better positioned to outperform

For investors, the bottom line is that the current market environment – marked by strong loan and CLO debt technicals that are driving spreads tighter – highlights the value of the ability to refinance CLO debt after the non-call period expires. Managers with strong credit performance and who actively evaluate CLO market opportunities will have the greatest ability to provide better economics for equity investors as new CLO debt is issued at today’s lower market spreads. This ability to adjust to changing market conditions and potentially lower debt costs is a key benefit of investing in CLO equity.

To learn more about CLO equity, read our primer, CLO Equity: How It Works – and Why It’s Compelling Now.