CLO Equity Holders Reset Deals at Record Pace: Credit Weekly

Investors in the riskiest portions of collateralized loan obligations are seeing their returns get juiced thanks to the biggest wave of resetting on record.

Resets, a form of refinancing for CLOs, surged to a US record of more than $26 billion in August, according to data compiled by Citigroup Inc. that dates back to 2015. That’s a huge jump from the previous record for a month set in June, when they exceeded $20 billion for the first time.

Sales of new CLOs may soon come under pressure because there are too few loans to package into the securities. Even so, investors are eager to buy CLOs, which has helped bring spreads, or risk premiums, on the bonds to near their tightest level in more than two years. 

For holders of the riskiest kinds of CLO debt, known as equity, that creates an opportunity. If the structure’s funding is broadly cheaper because of refinancing, equity holders, who earn the difference between financing costs and coupon payouts to senior bondholders, can generate more profit. Resets also extend maturities, which can provide more opportunities to find cheaper loans in the future, helping both equity investors and money managers.

The trend is set to continue, with Citi expecting $80 billion to $100 billion more in reset and refinance issuance by the end of the year. The bank on Friday boosted its overall US CLO sales forecasts for the year. 

Investors in the other CLO tranches have so far been happy to go along with the resets because it keeps them allocated to the asset class. The deals coming to market have an average spread of about 140 basis points on the safest tranche after a debt rally, compared with more than 200 basis points over much of the last two years. 

Spreads “widened out in 2022 and 2023 amid risks from recession, defaults and the bank crisis” but have tightened since, said Himani Trivedi, head of structured credit at investment manager Nuveen. “It’s a good time for CLOs to extend their maturities and tighten the liability in the process.”

Investors in the riskier equity tranches have been seeing returns of around 13% on average this year, according to a Bank of America Corp. research note from Aug. 16. And while savings on spread vary between deals, refis and resets can increase cash flow somewhere in the range of 2 percentage points to 6 percentage points per year, said Trivedi.

For CLO managers, the resetting can be a boon even if the near-term interest savings are relatively minor, because it extends the maturity of the securities, generating fees over a longer period of time. It also boosts the amount of time that managers can easily trade in the underlying portfolio. Extending the maturity date by years can translate to more periods where loan prices drop into bargain territory, and then recover.

“The spread savings could be relatively small, but it still might make sense because you’re adding optionality,” said Dan Sherry, a portfolio manager at PineBridge Investments. “The manager has more years and can add more value by actively trading.”

Resets make up nearly 40% of CLO issuance in 2024, far more than in recent years, according to data compiled by Bloomberg News. A similar phenomenon is playing out in Europe, with issuance of resets and refis helping to drive overall sales growth for the year.

Resets for CLOs issued more recently are often motivated by lower yields, while those for securities originally sold a few years ago are often motivated by extending maturities. About $400 billion of securities in the US CLO universe are candidates for resets by the end of the year if spreads hold at current levels, according to Maggie Wang, global head of CLO research and private credit strategy at Citi.

The “CLO reset wave should continue as plenty of deals are out of non-call periods and in the money to expect the reset or refi option,” Wang said. “Both CLO equity investors and managers embrace it.”

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