Post-financial crisis European collateralized loan obligations (CLO 2.0) have learned lessons from their pre-crisis CLO 1.0 predecessors, introducing several protections in their transaction documents and structures. Amongst them, is the ability to adjust liability costs, through resetting, refinancing, or reissuing (see the Appendix for further information on the CLO lifecycle and refinancing types). Following a refinancing peak in 2021, the trend reversed to the point that after April 2022, refinancings and resets dried up (Madison Park Euro Funding XV CLO reset its liabilities back in May 2022).

This dearth has led several CLOs to exit their reinvestment periods and initiate the march toward amortization. Given their sequential repayment, the senior notes are repaid first. Because these notes typically carry the cheapest costs, their repayment will increase the weighted-average cost of debt (WACD) for the CLO, reducing the available excess spread and causing tension among CLO stakeholders given their different objectives. While debt investors may be keen to receive their principal repayments and deploy the cash into products yielding higher returns, portfolio managers and equity holders would likely want to continue with the same CLO by reinvesting as much as they can (portfolio managers for fees and equity holders for remaining excess spread).

In this article, we gauge the pace of deleveraging for CLO 2.0s and compare them with their CLO 1.0 predecessors. We also take a closer look at 53 of our rated amortizing CLO 2.0s to assess how they fare against reinvesting transactions. Although the amortizing transactions' key credit metrics have generally deteriorated since they closed--with lower credit enhancement and a higher level of 'CCC' rated assets--their structural fundamentals remain intact.

European CLO Redemptions Have Yet To Gather Momentum

Most of our rated European amortizing CLO universe have taken the reinvesting route, subject to their post-reinvestment criteria, rather than deleveraging (see chart 1). This has led to a scenario where the notes may have a longer tenor than originally expected. A more typical scenario where the senior notes pay down eventually could result in an increased cost of debt, and the mezzanine and junior noteholders left with a concentrated portfolio of riskier assets. Since 2019, many European CLO 2.0s have exited their reinvestment periods, with several set to follow within the next 12-24 months (see chart 2).

Chart 1

Chart 2

Generally, once a CLO amortizes and exits its reinvestment period, the proceeds received from the underlying loans (repayments, prepayments, and sale proceeds) are used to repay the notes sequentially, starting from the most senior tranche. However, exiting reinvestment doesn't necessarily make CLOs static. Depending on their documentation, CLOs could continue investing in the amortization phase (though subject to stricter reinvestment criteria). Data indicate very few amortizing CLOs are deleveraging at their full pace, meaning most of these CLOs are continuing to reinvest into new assets rather than using the proceeds to deleverage the rated liabilities (see chart 1).

Historically, a loan's prepayment speed has generally dictated the pace at which the 'AAA' rated tranches redeem, driven by benign macroeconomic conditions where interest rates and defaults were low. Nevertheless, central bank interest rate hikes may also have slowed the loans' prepayment rate contributing to the slower deleveraging speed of a CLO.

In a world where the assets' default rate has been low, collateral quality tests and coverage ratios have been healthy, opportunities to purchase cheaper assets exist, and the liabilities costs in these amortizing CLOs are lower than for CLOs pricing today, the incentive to keep the CLO reinvested rather than deleverage is imperative and a common theme we are witnessing today.

CLO 1.0 And Amortizing CLO 2.0: A Closer Look At 'AAA' Redemption Timings

Of the over 300 EMEA CLOs 2.0s we rate as of the end of June 2023, almost 20% have exited their reinvestment period. Out of these, one CLO, which exited its reinvestment period in December 2019, still has its 'AAA' rated notes outstanding at about 35% of their original balance, while another two have a 100% note factor, despite ending their reinvestment periods in 2021 and 2022.

Where a handful of 'AAA' rated CLO 1.0 tranches had a very short life span (redeemed in less than three years), just one of the CLO 2.0 'AAA' tranches has redeemed in full as of the end of July 2023 (excluding the class X notes). CLO 1.0s were characterized by longer reinvestment periods (generally five to six years), as well as investing in instruments such as collateralized debt obligations (CDOs) of asset-backed securities (ABS) and/or synthetic assets, which tended to have longer weighted-average lives (WALs). Based on the amortization pace of these amortizing CLO 2.0s until end-July 2023, it appears that 'AAA' notes in these CLOs will follow their predecessors, with most of them fully maturing in three to five years after the reinvestment end date, unless called earlier.

Chart 3

Amortization pace slows

We reviewed the amortization pace for CLOs that have redeemed at least 30% of their 'AAA' rated notes. Table 1 shows the asset amortization profile of these 11 CLOs as of July 2023. Looking at the current asset portfolio composition in these CLOs (as of July 2023), it appears that on average only 8% of the portfolio will amortize in 2023-2024, with peak amortization only happening by end-2026--therefore delaying the notes' redemption even further (see chart 4).

Table 1

Chart 4

CLO managers and increasing costs

The other dilemma CLO managers will face is how to manage the WACD in these amortizing CLOs. As the cheapest tranche in the capital structure ('AAA' rated notes) redeems, the CLO will be left with a concentrated asset portfolio and relatively higher paying mezzanine and junior notes. With stricter reinvestment criteria (in the amortization phase), and difficulty in managing collateral quality tests (especially the WAL test), portfolio managers will be assessing if it's economical to continue servicing the existing CLO.

To understand at what point it would become uneconomical (parking the other CLO documentation hurdles aside), we compared the WACD of these 11 CLOs versus the WACD of CLOs currently pricing (see table 2).

Table 2

Currently, the latest new issue CLOs have a WACD of around E+280 basis points (bps), and a blended weighted-average spread (WAS) of between 4.15-4.20. Considering the senior costs and fees remain unchanged, the excess spread for new transactions equates to approximately 102 bps.

If we compare this with the excess spread in these amortizing CLOs, only two CLOs have excess spread that is lower than in newer CLOs currently pricing, indicating these CLOs could be next to redeem early.

Amortizing And Reinvesting CLO 2.0: A Health Check

Looking at our rated European CLO 2.0 universe, almost all transactions have reinvested in their amortization phase (using the post-reinvestment criteria). Considering the elongated risk period in these amortizing CLOs, we reviewed their credit metrics by comparing them with their reinvesting counterparts. We typically consider these metrics when reviewing our ratings on CLOs before considering a rating action.

Credit enhancement decreases for amortizing CLO 2.0s

As a CLO deleverages, the credit enhancement typically improves for the rated notes. This has been the case for most, although not all amortizing CLOs (see chart 5). Almost 27% of the 'AAA' rated notes in amortizing CLO 2.0s now have lower credit enhancement than they did at closing. The biggest fall was 2.55%, for a CLO that started to amortize in May 2022 and still has a 'AAA' rated note outstanding at 99.9% of the closing balance. The average drop in credit enhancement from closing is about 70 bps.

Chart 5

CLO portfolios' weighted-average lives reduce

The CLO's WAL is the weighted-average time for the portfolio to amortize. Typically, events such as prepayments will reduce a CLO's WAL, while investing in a loan with a longer maturity will increase it. Furthermore, features like amend-to-extend agreements or restructuring of the underlying loans will also typically affect the WAL.

For all 53 amortizing CLOs included in this study, the fundamental structural mechanics remain intact in the amortization phase, with the portfolio's WAL reducing as it enters its amortization phase. However, three amortizing transactions have a WAL closer to that of the reinvesting CLOs.

Chart 6

S&P weighted-average rating factor increases for amortizing CLOs

The S&P weighted-average rating factor (SPWARF) of a CLO portfolio indicates the overall credit rating distribution of the portfolio weighted by each asset's par balance. The average SPWARF for amortizing CLOs is 2,852--only slightly lower than for reinvesting CLOs (2,879). Almost 42% of amortizing CLOs have higher SPWARFs (i.e., worst overall credit rating distribution) compared with the reinvesting CLOs we rate, and nine amortizing CLOs have SPWARFs above 3,000. Eight of these nine CLOs exited their reinvestment periods back in 2021-2022 and their average 'AAA' note factor is about 77% (see chart 7).

Chart 7

Amortizing CLOs have more 'CCC' rating concentration and defaults

Amortizing CLOs may see an increased percentage of 'CCC' or 'D' rated assets due to the pool reduction. A higher proportion of 'CCC' assets in a concentrated portfolio could result in a higher SPWARF, which could negatively affect the ratings.

Almost 83% of our amortizing CLO universe has more 'CCC' rated assets than reinvesting CLOs. This has typically been the case due to amortizing transactions' portfolio concentration. However, 68% of these CLOs have not started to fully amortize their notes (they still have a note factor above 90%). Similar to 'CCC' rated assets in amortizing CLOs, 68% of the amortizing universe have higher defaulted assets than reinvesting CLOs. On average, exposure to defaulted assets in the amortizing pool is less than 1% of the overall pool size and considering all coverage tests passing and higher credit enhancement than CLO 1.0s, we do not currently consider these CLO 2.0s to be at risk of downgrades (see charts 8 and 9).

Chart 8

Chart 9

Weighted-average spreads for amortizing portfolios hold steady

One of the most important pillars of managing an amortizing CLO is the WAS generated on the portfolio. This is because, as the 'AAA' rated notes amortize, the cost of debt increases, which could negatively affect the ratings on the junior notes. The average WAS for amortizing CLOs as of June 2023 was 3.64%, partly due to the reinvestment restrictions CLO managers face. Only one amortizing CLO had a higher WAS than the reinvesting CLOs, but this CLO has historically had more bonds, which typically yields higher returns (see chart 10).

Chart 10

Concentration risk could exert pressure on ratings

As the portfolio exits its reinvestment phase and enters its last stage of amortization, defaults or increases in low-rated assets in a concentrated pool could increase rating pressure on the CLO tranches (see chart 11).

Chart 11

Amortizing CLOs have negative cash

Where the majority of reinvesting CLOs have overtraded (holding negative cash as of the July/August 2023 investor reports), only 11% (six CLOs) in our rated amortizing universe have unsettled trades resulting in them reporting negative cash (see table 3). All six have on average ended their reinvestment period in third-quarter 2021 and have 99.5% of their 'AAA' rated notes' balances outstanding.

Table 3

European CLO 2.0 Are Unlikely To Amortize Any Time Soon

Although our findings suggest that amortizing CLOs generally fare slightly worse than their reinvesting counterparts on some of the key credit metrics we track, not all amortizing CLOs are actively reinvesting. Some of the amortizing CLOs have continued to deleverage and only reinvest when absolutely necessary. Currently, with low defaults and 'CCC' exposure--as well as broadly positive credit metrics--amortizing CLOs are not showing signs of downward rating pressure.

Our data show that CLOs tranches may have a longer than expected life. In a low defaults scenario, the increase in asset margins and the lower current spreads on the liabilities is helping arbitrage work, making the economic proposition more interesting for equity holders, less so for senior and mezzanine debt holders.

Despite several CLOs exiting their reinvestment phase, it appears that most of them have not yet initiated substantial repayment on their notes. This highlights the importance of reviewing the reinvestment criteria during and after the reinvestment period, ensuring that the investors are aware and comfortable with the potential longer tranches' life.

Nevertheless, more recent new CLO issuance seems conducive of a supportive environment for a return of reset and refinancing activity. When considering the current cost of debt, compared to the original one, and the non-call period, we expect an increase in reset and refinancing activity this year, with a pickup in 2024. Such activity will affect current CLOs, further reducing the negligible amortization of those amortizing transactions.

Appendix: The CLO Lifecycle And Refinancing Types

In practice, CLOs rarely make it to the stated legal final maturity due to large part of amortization of the higher-rated/lower-cost debt tranches as soon as the reinvestment period ends. The common understanding in the CLO space has been that the 'AAA' tranche is the first to amortize and is typically fully paid off by years six or seven. Assuming the transaction is not called, the amortization period starts after the reinvestment period ends. Proceeds from prepayments and recoveries are used to pay down tranches that start to amortize based on the order of their seniority in the structure.

As CLOs do not have mark-to-market tests, they only depend on cash flow performance (e.g., timely payment of principal and interest), ratings, maturities, and defaults of the underlying bank loans. Therefore, CLO managers are not forced sellers during periods of market volatility and can buy and sell assets to take advantage of opportunities in the market to find value or minimize losses on deteriorating credits. Some portion of principal proceeds can potentially still be reinvested in the amortization phase; if the transaction language allows it (typically proceeds from unscheduled payments or credit impaired/improved proceeds), and the manager is in compliance with maintenance tests.