Key Takeaways
- An accumulation of higher cash balances in European CLOs has in part been driven by limited refinancing opportunities since 2021, a high prepayment rate, and restrictive conditions to reinvest.
- Uninvested cash is an inefficiency for CLOs when maximizing present value and the internal rate of return to equity. Hence, documentation is evolving as managers seek innovative solutions to address this inefficiency and "make the cash work" in their CLOs.
- CLO documentation may become more flexible in future as managers prepare for post-reinvestment period life.
European collateralized loan obligations (CLOs) are seeking more ways to "make the cash work". The accumulation of higher cash balances has in part been driven by limited refinancing opportunities since 2021. As a result, CLOs have instead exited their reinvestment periods and, due to a high prepayment rate, have accumulated material uninvested cash balances (see chart 1).
Chart 1
Before diving deeper into the cash-utilizing features S&P Global Ratings is observing in CLOs, it's important to set some context around the CLO product, its primary purpose, and why we believe these features are noteworthy to highlight.
- Once a CLO's reinvestment period has ended, the conditions to reinvest deliberately become more restrictive thereby resulting in an accumulation of principal proceeds in the CLO's principal account. CLO managers maintain the ability to reinvest cash in eligible investments however, remain restricted to short-term debt which generates relatively lower returns, resulting in a drag on CLO equity returns (in some cases also referred to as negative carry). See chart 1 and for more information, "Delving Deeper: Why Do CLOs End Up With So Much Cash?".
- CLOs are primarily arbitrage investment vehicles which look to maximize the return on a portfolio of corporate debt and provide excess returns to CLO equity. The equity tranche, assuming it's issued at par, typically provides investors with eight to 10 times leverage on the portfolio and acts as the first loss piece upon defaults. Attracting CLO equity depends largely on the arbitrage potential between the cost of CLO liabilities and the interest generated on the portfolio as equity generally receives the residual cash flows. As such, material uninvested cash balances are an inefficiency for CLOs when maximizing present value and the internal rate of return to equity, and both CLO structures and their respective documentation have evolved as managers seek innovative ways to maximize returns.
Here, we explore several ways in which European CLOs are utilizing their cash positions in the most arbitrage-efficient way possible. This ranges from features such as the "synthetic" distribution of principal cash to improve overcollateralization ratios, to applying discount rates to cash-trapping mechanisms to fast-forward CLO equity returns.
Table 1 summarizes the most recent cash-utilizing features being built into CLO documentation and how this affects CLO returns and tests.
Table 1
Payment Dates: Repay Sooner, Save On Carry
European CLOs pay interest, and if applicable principal, quarterly, however additional payment dates, which repay liabilities earlier, can reduce negative carry and improve the present value of equity returns.
The ability to repay CLO investors earlier than their scheduled payment dates typically comes in two forms in the European CLO market: Interim and unscheduled payment dates. Table 2 provides a comparative analysis between both features and the benefits they offer relative to the CLO instead holding a large principal cash balance.
Table 2
| Comparing interim and unscheduled payment dates | ||
|---|---|---|
| Interim payment dates | Unscheduled payment dates | |
| How does it work? |
- After the reinvestment period the issuer may declare the 15th day of any calendar month as a payment date subject to prior written notice to the rating agencies and the noteholders. - On this interim payment date, the issuer can redeem senior notes, in line with the note payment sequence, with the principal cash available in its account. The issuer can only redeem principal on the notes if interest proceeds are sufficient to pay all the accrued and unpaid interest on the notes redeemed (including any deferred interest). - If a note is only partially redeemed the remaining balance will continue to accrue interest until the next payment date. However, unlike a standard payment date interest cannot be used to pay amounts junior in the waterfall, i.e., interest is not distributed to junior or subordinated noteholders. |
- The issuer may designate any date, during the due period, as a payment date subject to timing conditions, i.e., the parties are given sufficient notice, and the new payment date is not within five days of another payment date. - Although not a "new concept", unlike an interim payment date, an unscheduled payment date can only occur after all the rated notes have fully redeemed. |
| Why is it useful? | - Redeeming the senior notes before a scheduled payment date helps to avoid negative carry and may also help to cure par value tests. This is because the denominator of the test reduces when liabilities are repaid. Curing par value tests in this way enables the manager to continue trading if the condition to satisfy coverage tests was a constraint. | - An unscheduled payment date brings forward interest distributions to equity which therefore improves the present value of cash flows and the overall internal rate of return. |
| S&P Global Ratings' view |
- For structured finance instruments, and covered bonds, our ratings typically address the likelihood of timely interest payments and ultimate principal repayment. As such, if the notes are redeemed at par plus accrued interest, we view this concept to be in line with our framework. - The priority of payments is respected as no interest distributions can be made in junior positions of the waterfall and the transaction must have sufficient interest proceeds to pay accrued interest on the portion of the notes being redeemed. Furthermore, we look to the manager to determine if sufficient interest proceeds will be available to pay senior fees, expenses, and timely interest on the senior notes on the next scheduled payment date. |
- Since the rated notes will have fully redeemed before this concept can be utilized, we do not opine. |
| Where to find this language in a typical offering circular | - As part of condition 7 and typically below the ability to purchase the notes. | - As part of condition 3 and typically below the "Accounts" section. |
Par Value Test Calculations: Do The Math
Par value tests are primarily designed to protect CLO investors from par erosion and defaults and losses in the underlying portfolio by ensuring that interest and/or principal proceeds cure predefined overcollateralization levels on each payment date. At the same time, a CLO's reinvestment conditions also require compliance of the same par value tests to ensure that the underlying portfolio's par value is generally maintained or improved every time the CLO manager is trading the portfolio.
In both cases, recent CLOs have been calculating their par value tests by pre-determining the repayment of the CLO notes by an amount equal to the amount of principal cash the CLO currently holds, and in the case of par value test calculations to continue reinvestment, ahead of when the payment is actually made to CLO investors. Utilizing the calculation of cash (1) in the CLO waterfall and (2) for reinvestment conditions in this manner allows the CLO to maximize equity returns and continue to reinvest for longer. Table 3 summarizes how cash is utilized for par value tests and the benefits they offer in both the instances we mention above.
Table 3
| Par value test calculations | ||
|---|---|---|
| Par value test calculations in the CLO waterfall to maximize equity returns |
Par value test calculations to continue reinvestment |
|
| How does it work? |
- Post reinvestment period the par value tests in the waterfall are calculated after applying the principal available for distribution on the notes. - To do so, cash is removed from the numerator of the par value test calculation and the portion of the note to be redeemed is removed from the denominator. - For example: if the class A/B par value ratio is 138% (assuming a €400 million portfolio and a €290 million class A and B liability balance) then removing €20 million of cash from the numerator and €20 million of liability repayment from the denominator increases the par value ratio by almost 3% to 141%. |
- After the reinvestment period one of the conditions for the manager to continue trading is that coverage tests are passing. When the manager tests par value tests the class balance in the denominator can be reduced by the amount of cash set aside to redeem principal on the next payment date. - In this way the concept is similar to the interim payment date however the class balance is only synthetically, or artificially, reduced in the calculation and the actual principal distributions still occur on the scheduled payment date. |
| Why is it useful? | - Reducing the denominator of the par value test calculation ensures that principal is used to cure par value tests, instead of interest, to maximize the interest then available in junior positions of the waterfall and improve equity return. | - Similar to the interim payment date this concept may enable managers to improve par value ratios and continue trading after the reinvestment period if the condition to satisfy coverage tests was a constraint. |
| S&P Global Ratings' view |
- In assigning ratings, we have adjusted our cash flow modeling and the impact on our breakeven default rates depends on the sequence of payments in the waterfall, as such: (i) When the note payment sequence is interest, then deferred interest, and then coverage tests, the impact has been low. (ii) When the waterfall tests the coverage ratios before paying deferred interest on the notes the impact has been more material since principal is first used to repay deferred interest on the controlling class of notes and then used to redeem principal. In this way less principal is available to redeem the notes and interest continues to flow down to equity. |
- The principal amounts set aside are done so irrevocably and can only be applied toward principal repayment of the notes. - The waterfall, in specific circumstances, permits the use of principal to cover an interest shortfall, rather than to repay the debt. This could result in the denominator of the overcollateralization calculation, after the payment date, differing from what was calculated during the period. We do not view this as a risk since the interest coverage tests need to be satisfied after each reinvestment, meaning the portfolio is currently generating sufficient interest. |
| Where to find this language in a typical offering circular |
- As part of condition 3, in the "Application of Interest Proceeds" section when calculating the par value tests or, - In the "Principal Amount Outstanding" and "Adjusted Collateral Principal Amount" definitions. |
- In the "Principal Amount Outstanding" definition and "Adjusted Collateral Principal Amount" definitions. |
Chart 2 provides an example of the language we typically see reflected in the CLO waterfall.
Chart 2
Interest Collection: It's All About Present Value
The timing to collect and distribute interest on the portfolio is a key driver of equity return, which is why recent CLOs are including updated transaction language aimed at minimizing cash trap from interest smoothing accounts and extending due periods to ensure that interest distributed on the payment date is maximizing equity returns.
Table 4 summarizes and compares two notable evolutions in CLO documentation which aim to utilize interest proceeds in the most arbitrage-efficient way possible: The application of discount rates for interest smoothing mechanisms and the optionality to extend due periods.
Table 4
| Comparing interest smoothing with due period extensions | ||
|---|---|---|
|
Interest smoothing calculations to minimize cash trap |
Due period extensions to capture maximum interest |
|
| How does it work? |
- We have seen variations of the interest smoothing language which aim to minimize cash set aside from semi-annual payments of interest. To do so, the transaction typically sets a threshold for the percentage of semi-annual obligations in the portfolio or relies on the transaction otherwise having sufficient interest to service the interest due on the notes, i.e., by looking at par value and interest coverage tests for the next period. - A new concept has recently emerged, whereby the cash that is set aside is discounted by the interest rate payable on the account such that by the end of the due period the cash set aside plus the interest generated equals the one-quarter worth of interest which would have otherwise been smoothed. |
- Interest collections, up to a limited number of business days before the payment date, can be sent to the interest account for distribution even if they are received after the determination date. |
| Why is it useful? | - Minimizing the cash required to be set aside in the interest smoothing account increases the interest available for distribution on the next payment date and so improves the present value of cash flows for CLO equity. | - Any additional cash proceeds distributed on the payment date improves the present value of cash flows for CLO equity. |
| S&P Global Ratings' view | - We analyzed the calculation used to discount the cash proceeds to be set aside and concluded that by the end of the due period, the cash set aside plus the interest generated was equal to the one-quarter worth of interest which would have otherwise been smoothed. |
- Our cash flow modeling assumes payment periods on a quarter-by-quarter basis and so our analysis does not consider the determination cut-off date. - We are comfortable that there is no "double counting" i.e., amounts captured by the due period extension in period one are not given credit in the interest coverage tests for period two. |
| Where to find this language in a typical offering circular | - In the "Interest Smoothing Amount" definition. | - In the "Due Period" definition. |
Delving Deeper: Why Do CLOs End Up With So Much Cash?
European CLOs typically have a reinvestment period of between four to five years, during which time the manager is actively trading the portfolio. Therefore, any cash received from asset redemptions, or from asset sales, is reinvested in substitute assets. Once the reinvestment period has ended the manager's ability to continue trading is limited, and so cash can begin to accumulate in the principal account to either redeem the senior notes or source substitute assets which meet the more restrictive post-reinvestment period conditions.
As a result, the average cash balance across European CLOs is highly range-bound between very actively traded transactions, which often have negative cash balances to generate more interest on the assets and improve equity returns, and less actively traded transactions which often have neutral to positive cash balances (see chart 3).
Chart 3
The time remaining in the reinvestment period often determines whether a transaction is actively traded. As a result, transactions which exit their reinvestment periods are often subject to stricter reinvestment criteria and tend to have higher cash balances (see chart 4).
Chart 4
Looking Forward
We believe that the features discussed in this article are captured by our ratings, however, they may still affect the performance of the notes and the impact may not be the same for senior and junior noteholders. For example, an interim payment date may benefit senior noteholders who receive principal redemption before a scheduled payment date, but if by doing so, the par value tests improve and the manager can continue to reinvest, this may be detrimental to junior noteholders in the long run.
CLOs continue to innovate and we expect that managers will develop more features to solve for inefficiencies and maximize returns.
Related Research
- CLO Pulse Q2 2024: Movers And Shakers In The Top 50 Obligors In European CLOs' Portfolios, July 30, 2024
- Twenty-Five Years Strong: European CLOs' Lifetime Default Rate Is Only 1.5%, April 18, 2024
- European CLOs: The Long Road To Amortization, Sept. 6, 2023
- CLO Insights: New Features In European CLOs For 2022, Sept. 7, 2022
- How Is European CLO Documentation Evolving To Address ESG Considerations?, June 9, 2022
- New Features Continue To Appear In European CLOs, Sept. 1, 2021
- A Closer Look At How Uptier Priming Loan Exchanges Leave Excluded Lenders Behind, June 15, 2021
This report does not constitute a rating action.
| Primary Credit Analyst: | John Finn, Paris +33 144206767; john.finn@spglobal.com |
| Secondary Contacts: | Sandeep Chana, London + 44 20 7176 3923; sandeep.chana@spglobal.com |
| Emanuele Tamburrano, London + 44 20 7176 3825; emanuele.tamburrano@spglobal.com |
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