Here's How CLOs Are Really Surprising Investors: KBRA

Credit analysts, reporters and others have worried about the possibility that the commercial real estate loans inside collateralized loan obligations (CLO) could go bad.

Roy Chun and other rating analysts at Kroll Bond Rating Agency (KBRA) say in a new report that, in the real world, borrowers with loans inside CLOs are surprising investors in another way: Many of those borrowers are doing so well that they're paying their CLO loans off early.

In recent years, "the prepayments led to increases in credit enhancement levels," the analysts write in the KBRA CLO prepayment report.

KBRA has responded to recent early CLO loan payoffs by increasing 11 commercial real estate CLOs' ratings, the analysts write.

But the CLO prepayments could make managing CLO assets a little more challenging for life insurers' investment managers.

Life insurers ended 2017 with $60 billion, or about 1.5% of their cash and invested assets, in CLOs, according to Moody's Investors Service.

Many life insurers are hoping CLOs will provide reasonably steady income over a designated period of time, to help make sure that cash will arrive when the insurer is supposed to send payments to life insurance benefits claimants, annuitants, and other customers.

Commercial real estate companies often borrow money through arrangements with flexible prepayment rules, the KBRA analysts write.

That flexibility makes it harder for observers to determine the duration and maturity of commercial real estate CLO notes, the KBRA analysts write.

What State Insurance Regulators Say

The Capital Markets Bureau, part of the National Association of Insurance Commissioners (NAIC), talks about CLO prepayment risk in a CLO primer posted in August 2018.

The bureau says in the primer that CLO net yields are often attractive, even after CLO manager fees and expenses are subtracted.

In a discussion of CLO risks, the bureau suggests that falling interest rates could increase prepayment risk, by encouraging borrowers to refinance floating-rate loans.

Early CLO loan payoffs can reduce the underlying CLO portfolio principal value, the bureau says.

"CLO managers are then tasked with reinvesting the proceeds in new, economical (leveraged bank loan) opportunities," the bureau says.

CLO Loan Prepayment Details

In the new commercial real estate CLO prepayment report, the KBRA analysts say they looked at 428 commercial real estate loans and found that 24% of the loans were paid off.

About 89% of the loans paid off were paid off before their original maturity date, the analysts write.

The analysts note that the borrowers tend to pay off the loans early partly because of the nature of the loans: Many of the borrowers use the money to renovate outdated buildings, to increase occupancy rates and attract tenants willing to pay higher rents.

Once the borrowers renovate the buildings and increase their cash flow, "financing options become available with lower rates, longer terms (if desired), and potentially more proceeds," the KBRA analysts write.

The analysts say the following factors seem to increase the likelihood of early CLO loan payoffs:

Initial loan terms less than or equal to 30 months.
Loan balances under $15 million.
Simple, easy-to-implement business plans.
Use of loans to renovate multifamily housing.

The KBRA analysts write that commercial real estate CLO watchers need to recognize the possibility that conditions could change, and that defaults could eventually become more of an issue than early loan payoffs.

The CLO market is "still a relatively young market which has not experienced a full real estate cycle," the analysts write.

When the economy cools, the CLO loan borrowers could come to lenders asking for more time to make their payments, rather seeking opportunities to pay off loans early, the analysts write.

Time will tell as the sector seasons," the analysts conclude.

Resources

A copy of the KBRA CLO prepayment report is available, behind a log-in wall, here. Members of the public can see the report by registering for a free account.

The NAIC Capital Markets Bureau CLO primer is available here.

— Read In Leveraged Loans, It's Beginning to Look a Lot Like 2008, on ThinkAdvisor.

— Connect with ThinkAdvisor Life/Health on LinkedIn and Twitter.