The CLO duration curve has flattened significantly, based on the pricing of several refinancing and reset deals since the start of the New Year.
A CLO portfolio manager said that investors are complacent on the duration risk of longer dated bonds, and are overly confident that the bonds will be called at the first opportunity in a strong market.
A refinancing deal that closed on Tuesday, Seix Investment Advisors’ refinancing of Mountain View X CLO, sold triple-B rated notes with a coupon of 260bp over Libor. The deal has a reinvestment period of less than two years, during which time loans can be traded in and out of the portfolio.
In contrast to this, HPS Investment Partners on Wednesday reset a 2014 transaction, pricing BBB- rated notes with a discount margin of 255bp over Libor. The deal has a five year reinvestment period with a two year non-call date.
In a rallying market, CLO managers are likely to take the first available opportunity to call the deal, and so longer dated bonds are being priced with this assumption in mind. But this might not happen if the market softens before then.
“A lot of reset paper is being priced to first call, and investors are not taking into account the risk that paper may extend for a long time beyond that. The market is treating a two year reinvestment period the same as five — we would consider that a pretty big inefficiency,” said the portfolio manager.
“If you can get your hands on shorter dated paper, it doesn’t offer an outstanding spread but it offers relative value compared with the rest of the CLO market,” he added.
The first new issue deals of the year emerged this week. On Wednesday, MidOcean Credit Fund Management priced its fifth CLO through Goldman Sachs. The triple-A piece of the $512m deal was priced at 115bp over Libor.
It was followed by Octagon Investment Partners, which priced a new $511.7m deal, Octagon Investment Partners 35 CLO, via arranger Bank of America Merrill Lynch. The triple-A notes were priced at 106bp over Libor.
CLO investors are bracing for further spread compression, although the rising Libor rate does give some room for more tightening, said the investor. “Top tier managers are coming in with triple-A prints in the low 100bp area, and I would say in the next 30 days we’ll see triple-A notes below 100bp,” he said.