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US CLO market will adapt and continue to thrive despite regulatory headwinds

June 6, 2014
- 12:53 pm

The CLO 2.0 market in the US has enjoyed a resurgence in 2013/14. According to Royal Bank of Scotland, the market grew from USD55.2bn in 2012 to USD81.6bn in 2013. Last month, CLO issuance reached USD11.8bn, a level not seen since May 2007, bringing YTD issuance to USD34.5bn; slightly up on USD30.2bn for the same period last year. According to S&P Capital IQ LCD, the week ending 4 April saw USD2.75bn of new CLO assets come to market, continuing the market momentum of March, in which USD11.15bn of CLO assets were issued.

“The numbers are really positive this year. April was the largest month for issuance since the financial crisis,” says Andrew Schofield, Director of Alternative Investments at KPMG in the Cayman Islands. Despite acknowledging that dark clouds of regulation still linger on the horizon, Schofield believes that the US CLO market will continue to prosper and deliver robust performance going forward.

“There’s been a significant uptick in investor interest in CLOs since 2012, which has been largely driven by a couple of factors. First, the performance of CLOs as an asset class through the credit crisis was good. Second, given that we are currently in a historically low interest rate environment, CLO assets offer pretty good returns when you look at the credit quality and historic default rates associated with them,” comments Schofield.

Indeed, the fact that central banks have persistently kept interest rates at near-zero levels since the financial crisis has helped propel leveraged loan issuance as corporates seek to take advantage of favorable financing (and refinancing) conditions. This goes some way to explaining the resurgence in the US, as supply dynamics look to keep pace with demand.

“Total loan outstandings were approximately USD600bn in 2008 and that only backed off slightly in 2010 through 2012. Last year, and in to 2014, we’ve seen the loan market increase substantially to levels in excess of USD700bn,” says Schofield. “At the IMN CLO conference in New York last month the general consensus was that we would at least match the 2013 level of loan issuance. The sentiment was that the US CLO market was in a good place even though there are some regulatory headwinds ahead that may slow things slightly.”

Those regulatory headwinds are addressed below but before Schofield opines on those he expands briefly on why CLOs have once more become attractive to institutional investors.

As an asset class CLOs have stood up well to severe stress testing through the financial crisis compared to other asset classes.

“If you look at the performance of global CDOs ex CLOs over a five-year period, the investment grade loss rate was nearly 50 per cent according to a 2012 report by the Loan Syndications and Trading Association. By comparison, the loss rate over the same period for global CLOs was less than one per cent.

“In today’s low rate environment CLOs offer quite attractive returns. Investors are increasingly comfortable that CLO’s and the loans that underlie them will perform in a predicable manner through the credit cycle, as demonstrated through the stress of the financial crisis. This is in contrast to other securitized asset classes such as CDO’s and RMBS where losses were in excess of expectations.

On top of the proven capability of CLOs, AAA spreads have started to widen slightly this year as US banks – the largest investors of AAA CLOs – have started to pull back amid regulatory uncertainty. This has created an opportunity for investors to take advantage of, albeit a limited one.

“Pre-crisis AAA tranches were trading at a 200 basis point spread over LIBOR. That widened out significantly through the crisis however over the last couple of years spreads have consolidated at around the 135 basis point level. Even though spreads have widened out recently to 145-155, in a broader context they are still trading at a relatively tight levels” explains Schofield.

One other reason for the growth of the US CLO market this year is increased investor confidence simply due to the improved structure of CLOs 2.0 compared to pre-crisis CLO 1.0 vehicles. Lessons have been learned.

Compared to pre-crisis structures there is more subordination, improvements regarding the flexibility to extend financing and increased collateral requirements. “The CLO 2.0 environment is one that has taken the experiences of the financial crisis and translated the lessons learned into a structure that is more robust” observes Schofield.

Regulatory headwinds: a threat to CLO growth?

There are two regulatory headwinds on the horizon: the Volcker Rule and risk retention rules. The former could pose a threat to US banks by preventing them from continuing to invest in CLOs.

This resulted in a drop off in CLO issuance at the start of the year amid regulatory uncertainty. One of the problems that banks face is that CLOs that own bonds, and not just loan collateral, are regarded as covered funds. Under Volcker, banks are prevented from having an ownership interest in a covered fund. Unsurprisingly, US banks feel aggrieved at the prospect of having to divest their interests in CLO assets that do not conform to the Volcker Rule. It could lead to in excess of USD65bn of CLO paper being shed from banks’ balance sheets.

In April, the US Federal Reserve gave some much needed clarity on the issue by announcing that the compliance requirement for US banks would be extended by two years to July 2017.

“It removes the immediate threat of banks having to divest CLOs. The recent clarifications and subsequent statutory changes have meant that a lot of potential concerns and dampening of demand from a Volcker Rule perspective have dissipated.”

“I don’t anticipate a cliff dive in CLO issuance going forward. For the majority of CLOs now being issued, the Volcker requirements are being factored in to the structuring process and this will allow banks to continue holding investments in CLO’s,” says Schofield.

Evidence of this can be seen by the fact that Apollo Global Management LLC and Highland Capital Management LP – two major US CLO managers – have recently structured CLOs that will not hold any bonds, so as to comply with Volcker. Whilst banks might initially have feared the consequences of Volcker, the evolution of the CLO vehicle, which are now referred to as CLO 3.0, shows that the industry is once again able to innovate within the confines of regulation.

“The CLO 3.0 structure will factor in an option to include bonds if regulations change in the future (referred to as a springing bond bucket), or will simply remove the provision for bonds out of the structure altogether. Once the regulatory uncertainty for banks of holding CLOs has gone, we can look at how to optimize the CLO structure within a new regulatory framework,” states Schofield.

Of bigger concern, in Schofield’s view, are the risk retention rules legislated in the Dodd-Frank Act. These have the potential to reduce competition at the manager level in the market because of the additional capital requirements that may be placed on them. Currently this is expected to be 5 per cent of a CLO’s total assets. For smaller and mid-sized CLO managers, having 5 per cent ‘skin in the game’ will inevitably lead to reduced participation.

“In a study that the LSTA put together, the challenges of the proposed risk retention rules are highlighted by considering that a 5 per cent stake in a USD500mn CLO would equate to USD25mn. If you’re earning 50 basis points and the deal runs for seven years you’re only going to earn USD17.5mn over the life of the CLO for something that has required a USD25mn investment up front.

“Over the last couple of years we’ve seen a large number of new managers entering the market but these risk retention rules could dampen participation and the number of CLOs being issued,” says Schofield.

The industry is currently lobbying hard to focus the risk retention rules on the equity tranche – the most junior and high risk tranche of a CLO where investors enjoy the highest yield returns but are the first to incur any losses. “That would help protect investors, which is ultimately the main objective of the risk retention rules,” says Schofield.

That CLO managers will need to comply with such rules does seem unfair given that these are not financial intermediaries with their own balance sheet but merely fee-taking agents that work on behalf of the interests of their investors; just like any other mutual fund or hedge fund manager. As an Oliver Wyman report entitled Risk Retention for CLOs: A square peg in a round hole? published in November 2013, states: “They [CLO managers] do not need or use substantial funding or capital themselves. From a functional role perspective, CLO managers are a poor and illogical fit for bearing risk retention requirements.”

“It’s become more of a political question as opposed to an underlying fundamental economic question. What impact risk retention rules are going to have remains uncertain. It’s very much in the hands of political lobbying groups in the US. Either way, I think risk retention is the biggest regulatory headwind the CLO market faces right now,” suggests Schofield.

The Volcker Rule for US bank participation in CLOs and risk retention rules under Dodd-Frank are regulatory issues for the industry to work through. But given that CLO 3.0 structures are already coming to market and CLO issuance numbers, overall, are on track to outstrip last year, it looks like the CLO resurgence can, and likely will, continue.

“There are some regulatory headwinds in place but the industry as a whole has demonstrated an ability to adapt and make structural changes to what is fundamentally a sound asset class. While there are concerns, in particular, around risk retention rules, the industry will adapt and continue to thrive,” concludes Schofield.