Supplemental indentures may pose risk to CLO investors, finds RBS

CLO investors need to track supplemental indentures in their deals as these can have a huge bearing on a CLO bond’s future cash flows, according to research by RBS. Such amendments to a CLO’s docs typically require rating agency confirmation and noteholder consent, although CLO strategist Justin Pauley points out that that in some cases noteholders are deemed to have consented unless they object within 10 days.

According to the report, 626 amendments received rating agency confirmation since the start of 2009. The nature of these amendments has changed in the last couple of years. In the early part of 2009, a number of managers turned to supplemental indentures to stave off an OC test breach as single-B loan prices slumped to close to 50 cents. More recently, the focus has been on extending a CLO’s life through lenghtening the reinvestment period or modifying the weighted average life test.

In one example the report finds that in September, a 2005 US CLO entered into a supplemental indenture which increased the WAL test covenant by two-and-a-half years. Surprisingly, this action did not require noteholder consent.

If a manager is given more room for manoeuvre to reinvest, equity returns are likely to stay higher for longer. However senior investors will have to wait longer for principal payments.