(Bloomberg) -- Dealmakers in US collateralized loan obligations are counting more than ever on an old friend: Japanese banks.
In a sign of how Japan's influence has grown, its regional banks have become a go-to buyer in the $1.3 trillion market — an important source of financing for junk-rated US companies. Along with bigger lenders and insurers, their loyalty to CLOs is a lifeline as some US buyers pull back.
Insurer Sumitomo Life Insurance Co. is considering buying more of the securities. Norinchukin Bank has resumed looking at CLOs after stepping away last year. And regional banks have been teaming up to take entire top-rated portions of some offerings, according to people with knowledge of the matter.
The firms are buying because of the high yields, with AAA rated CLOs yielding around 5.8% in the secondary market compared with about 3.6% for five-year US Treasuries. Japanese buyers need higher returns on their foreign bonds just to cover their rising hedging costs.
A show of force from the nation's investors, who own a fifth of top-rated CLOs by one estimate, will bolster the market for the bonds backed by leveraged loans. At the same time US banks have pulled back, as their deposits have fallen and capital requirements have increased. Taking risk in repackaged loans to high-yield companies is less appealing to many of them.
"There have been recent instances where Tier 1 well sought-after managers could syndicate an entire AAA tranche" to Japanese regional banks, said Vincent Pompliano, managing director and co-head of CLO platform at Benefit Street Partners, which puts together the securities and sells them. "It's helped to replace some of the investors that have been less active in CLOs, such as the US banks in particular."
Japan's investors are longstanding players in the CLO market. Norinchukin, a cooperative that invests for farmers and fishermen, was the world's second-biggest buyer at the end of September, according to SMBC Nikko Securities Inc. In 2019, the extent of Japanese ownership prompted the nation's central bank to warn that banks were vulnerable to a steep drop in prices if the global economy deteriorates.
Yet, as the fear of a US recession grows, Japanese banks and insurers are staying put in CLOs even as they retreated en-masse from the rest of the global debt market.
"Floating-rate CLOs are a beneficial investment for our profit stability and growth, so we are thinking of increasing holdings in the new fiscal year" that started in April, said Kouta Kanno, manager of the investment strategy section at Sumitomo Life. The search for yields means the Osaka-based insurer is buying AA and A tranches of CLOs, when it had previously only purchased top-rated portions, he said.
Last year's surge in dollar-hedging costs for Japanese investors — one of the biggest owners of global bonds — to more than 5% has eaten away most, if not all, of the returns they get from foreign sovereign debt. That makes CLOs attractive.
And for those like Kanno willing to take more risks, yields are almost at 7% for A rated CLOs, Bloomberg-compiled data show.
"Even on a hedged basis, the yield pick-up for Japanese investors is attractive in both US and European CLO AAAs, given the alternatives," Morgan Stanley strategists led by Charlie Wu wrote in a report this month. The Wall Street bank estimates that they hold around 20% of top-rated CLO tranches.
Biggest Holders
Norinchukin plans to resume purchases after stepping away last year, people with knowledge of the matter said in February.
A spokesman for the Tokyo-based lender said that Norinchukin would continue to include the debt in its portfolio.
Japan Post Bank Co. will continue to invest in CLOs with high credit ratings, a spokesman said, without providing details. The Tokyo-based firm was the sixth-largest holder of the debt globally as of September, SMBC Nikko said in a February report.
One regional bank plans to increase purchases of these securities, a person with knowledge of the matter said Wednesday, declining to be identified because the information is private.
CLOs don't come without risks, of course. For one thing, investors would be loading up on the leveraged loans just as expectations of a coming US recession grow. Interest payments on the securities will also fall, if the Federal Reserve lowers rates later this year as Fed funds futures traders expect.
Volatile Market
Prices of CLOs can be volatile and there have been times when they've fallen, so it's important to remain cautious, an official for Japan's Financial Services Agency said by phone Tuesday.
Massive selling by UK pension funds last year to meet margin calls highlighted how the industry may face sudden squeezes. At that time, US investors including Apollo Global Management Inc. scooped up the CLOs. Norinchukin though temporarily stopped buying then, according to people familiar with the matter at the time.
With US banks cutting purchases to meet regulatory capital requirements, and the loan market completely bifurcated, some managers of CLOs are struggling to sell them. Issuance in the US is down by about 1% so far this year compared to the same period in 2022, according to data compiled by Bloomberg.
Against this backdrop, the Japanese money marks a bright spot for the market.
"CLOs are one of the few attractive floating-rate debt products which can offer stable returns" for Japanese investors, said Tomohiro Miyasaka, chief securitization analyst at SMBC Nikko.
--With assistance from Lisa Lee and Adeola Eribake.
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