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Smaller, shorter, less risk: Amid downgrade wave, US CLOs shift structure

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Smaller, shorter, less risk: Amid downgrade wave, US CLOs shift structure

The formerly high-flying U.S. CLO market is undergoing a structural metamorphosis in the wake of the coronavirus pandemic, as this critical investor component to the $1.2 trillion leveraged loan asset class sees a flood of downgrades and a rise in defaults, and as the medium-term economic outlook remains uncertain.

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Accordingly, new CLO vehicles are opting for short reinvestment periods and contain less leverage than they did prior to the global economic shock caused by COVID-19.

A CLO's reinvestment period specifies the length of time a collateral manager can actively trade assets that underlie the CLO vehicle, and can purchase new assets.

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In particular, the once-standard five-year reinvestment-period CLO has disappeared from the market altogether since early March. Among the nine new U.S. CLOs that priced in April, three were static deals with no reinvestment period, four carried only a one-year reinvestment period, and two carried a three-year period.

Those trends continued in May, although there was a greater proportion weighted toward three-year deals, which made up five of the 15 vehicles that priced last month. There were also four deals with two-year reinvestment periods.

To some extent, this trend is simply a feature of the time-value of money during a period of extreme uncertainty. Investors unwilling to lock up cash for significant periods are demanding too high a cost of liabilities to make the math of the traditional CLO structure work; by shortening the duration of uncertainty, liability costs have come in to make the deal’s calculus more palatable to CLO equity and managers.

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Leverage on these deals is also declining, a sign that managers are looking to reduce risk. They are also taking in less in fees, as assets under management declines.

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Another common feature of today's CLO vehicles is managers’ retention of BB tranches, which is typically the most subordinated debt in the CLO capital structure.

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Finally, amid this market uncertainly, and as managers tend to existing portfolios and cast a wary eye on credit downgrades, CLOs are getting smaller. Through the first two months of 2020's second quarter, the average new-issue vehicle was $394 million, down considerably from $510 million during the first three months of the year, according to LCD.

CLOs are easily the largest investor in U.S. leveraged loans, by some estimates accounting for roughly $700 billion of the $1.2 trillion in outstanding loans.

This article was written by Alexander Saeedy, a Senior Reporter for LCD.

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