Refinancings and resets have flooded the U.S. CLO market this year. Indeed, on a quarterly basis, the first quarter has already featured the highest combined volume of this activity since the second quarter of 2018. Moreover, year-to-date refi and reset volume is already more than was recorded in all of 2020, according to LCD.
The main reason for the surge is the falling cost of liabilities, but the trend has been magnified by pent-up supply. Liability costs spiked in 2020, leaving little opportunity for CLO managers to cut the cost of funding.
Until last year, most deals were structured with two-year non-call periods at pricing. Thus, for refis and resets to be in the money, liabilities need to be tighter than they were two years prior.
Taking a look at just the triple-As, the average coupon is, over the last three months, lower than during any quarter in 2019. Consequently, the 2019 vintage is ripe for picking. The 2018 vintage, however, looks a little trickier when looking through the angle of averages, as every quarter that year registered a lower average triple-A coupon.
That said, while the current average three-month triple-A spread is 122 bps, deals in the last weeks have more frequently priced in a 100-110 bps range, while in February it was largely a 110-120 bps range. Such levels also put the 2018 vintage in the crosshairs.
Meanwhile, much of the 2017 vintage emerged from their non-call periods in 2019, when liabilities were wider than in 2017, and it is only just now that liabilities are coming down to a similar level.
More recently, last year there was a significant uptick in the number of non-call one-year deals. While these have yet to start rolling off, it is only a matter of time until they add to the deluge of resets and refis, given that many priced with sky-high liabilities.
In short then, 2021 is open to refis and resets from across the 2017-20 vintages, indicating that while refi/reset volume is already high, it could, if liabilities hold at current levels, rocket further.
This is supported by analysts at Morgan Stanley who wrote in February that "because of issuance/restructuring trends in 2017-20, an unprecedented proportion of deals (96%) would be callable by the end of 2021," adding that $263 billion of CLO notional paper would be callable by the end of the year, with a triple-A spread of L+120 bps or wider.
Some liability investors are also braced for such activity to keep rising, with one liability and equity investor commenting, "It is hard to ignore that funding costs have come down sharply already this year. We all expected it to be a busy year for refis and resets, but it is shaping up to be busier than we thought."
Another incentive for managers, and CLO equity investors, to reduce the cost of liabilities is the ongoing tsunami of loan repricings. In January and February, $126.6 billion of loans were repriced, which will have lowered the weighted average spread of collateral pools, thus reducing the excess spread in the deal and negatively impacting the arbitrage. On average, January and February's repricings lowered the cost of the term loans by 80 bps (including cuts to Libor floors).
Clearly, more managers are taking advantage and locking in significant cost savings. Indeed, those that have refinanced their triple-A tranches this quarter have locked in an average 33.3 bps reduction in the coupon. This is the largest reduction since the fourth quarter of 2018.
One other possible catalyst for further refi and reset activity could come from Asia. Japanese investors were for some time the anchor for many new issues. Should these start to be reset or refinanced, these investors will need to decide whether to pull back from the market. Should they decide that CLOs remain attractive, this will deepen the liability pool further, potentially bringing liability costs down again.
That said, if they do not, then the liability pool is shallower and should, along with a rampant new-issue market, keep a lid on how far liabilities can fall from here. Moreover, the spike in the 10-year Treasury yield will make it and other asset classes more attractive on a relative-value basis, again dampening demand somewhat. For now, however, it remains full steam ahead.