(Bloomberg) -- The biggest buyers of leveraged loans have gained the freedom to purchase more of the debt in recent months after refinancing their liabilities.
Fund managers that buy loans and bundle them into bonds known as collateralized loan obligations could have some $100 billion more to freely invest over time compared with a year ago, largely thanks to bankers springing into action in recent months to modify the vehicles.
When CLO managers raise money by issuing bonds, they typically have as long as five years to buy loans with the proceeds with relatively few investment restrictions, known as the reinvestment period. But they can restart the clock by refinancing the securities in transactions known as “resets.”
Last year, around 35% of CLOs were out of their reinvestment period, effectively restricting how they manage their portfolios of loans, according to Nomura. This year, managers have been been refinancing in droves and the share has been cut to 25%. Altogether over $172 billion of CLOs have been refinanced in 2024 through resets.
Those resets have been good news for Wall Street’s corporate finance engine, particularly for high-yield companies and private equity firms looking to fund buyouts. About two-thirds of all leveraged loans in the US are held by CLOs, and when managers have plenty of appetite to buy more, prices on loans in the secondary market are more likely to climb. The average price of a leveraged loan has grown by about 2 cents on the dollar over the last year, according to Morningstar LSTA Leveraged Loan index data.
“The frenzied level of activity for CLO new issuance and reset activity has turbo charged new loan demand from loan managers,” said Scott Macklin, head of US leveraged finance at Obra Capital.
A CLO that is close to, or outside of, its reinvestment period will likely stay away from newly issued loans because of the way the securities are built. They often won’t reinvest money they get from maturing loans, and will instead use the funds to pay down liabilities.
Managers have to abide by rules of the deal structure, such as limits on the average overall maturities of loans in a portfolio. For example, CLOs close to the end of their active investment periods have incentives to only buy loans with relatively short maturities. Those time tables are far less relevant for a reset CLO.
“For a lot of CLO managers the universe of eligible loans was getting smaller and smaller, until the resets started changing that,” said Jim Stehli, co-lead of Polen Capital’s CLO platform. “This should contribute to better conditions for issuing new leveraged loans.”
Starting last year, spreads for CLO debt began narrowing, making it economical for managers to reset deals. Bankers and lawyers sprang into action, keeping the $1 trillion market humming practically around the clock.
CLO equity investors also have reason to celebrate the wave of resets. Those buyers receive cash flows that are left over after other investors get paid. When CLOs reset, not only are the liabilities adjusted lower but investors often inject new dollars into the equity. Both can result in higher payments to the equity holders over time.
“A lot of seasoned CLO equity lost its option value [or reinvestment flexibility] as it aged, so this is just a new breath of life for equity investors,” said Paul Nikodem, a strategist at Nomura.
It isn’t just resets that are adding fuel to the CLO market. It’s also that older deals are being redeemed and others are getting paid down.
According to a recent JPMorgan Chase & Co. report, approximately $150 billion of CLOs are expected to exit the market next year, as equity investors choose to redeem older deals and as CLOs outside their reinvestment periods gradually return principal to investors. At that pace, even the current record rate of new CLO creation may not be enough next year to expand the market beyond its current size, the note said.
High levels of CLO redemptions may still indirectly add to aggregate demand for leveraged loans, according to Dan Sherry at PineBridge Investments. That’s because while CLO redemption candidates were probably not buying more loans anyway, money managers who get their principal back upon CLO redemption tend to redeploy the funds into new CLOs.
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