Loan price volatility benefits CLO equity
The guest argued that periods of price volatility in the loan market ultimately benefit CLO equity tranches by allowing managers to reinvest prepayments into discounted assets.
The argument
While spread tightening has pressured CLO equity returns over the past two years, price volatility allows managers to take par paydowns (which historically run at 20% per annum) and reinvest them into loans trading at a discount (e.g., 95 cents on the dollar). This process builds par value back into the CLO structure and enhances long-term cash flows to equity investors.
The thesis, stress-tested
✓ What validates it
- ✓An increase in loan prepayments during periods of market discount
- ✓Stabilization or widening of new-issue loan spreads
▸ Risks discussed
- ▸Elevated default and impairment rates which would disrupt cash flows
- ▸Prolonged mismatch where liabilities cannot be refinanced/called while asset spreads tighten
Hear it yourself
"So over the long term, these bouts of volatility, net net, are traditionally pretty good for CLO equity as it gives managers the ability to kind of reinvest proceeds in in their deals into into loans at a discount."
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