Changes that federal regulators are contemplating to the Volcker Rule could pave the way for CLOs to resume investing in high-yield bonds, something they have not been able to do for the last three years without putting themselves off limits to banks.

Last week, the Federal Reserve Board of Governors issued a 373-page proposal that would materially loosen restrictions on proprietary trading by banks as well as investments in "covered funds," a category that, as currently defined, includes both hedge funds and collateralized loan obligations.

The four other agencies responsible for implementing Volcker are expected to approve the proposal shortly.

While the Fed did not take a position on whether banks should be able to own CLOs that hold bonds, it requested comments on a number of issues that could put this back in play. These include the definitions of "covered fund," "ownership interest" and "loan securitization."

As the Loan Syndications and Trading Association noted in a report published on its website, "changes to any of these definitions could result in the end of the current prohibition."

To recap how Volcker, as currently written, impacts CLOs:

CLOs are considered to be covered funds because they rely on the same exemption from securities law as do many hedge fund and private equity funds from registering with the Securities and Exchange Commission.

Banks, which are among the biggest CLO investors, are prohibited from holding equity stakes in covered funds. In its original interpretation adopting the Volcker Rule for CLOs, the Fed stated even holding senior debt securities issued by noncompliant CLOs (i.e., those still with bond collateral) can represent ownership status because these securities confer the ability to hire or fire an investment manager.

Notwithstanding the fact that they are covered funds, CLOs can qualify for an exemption from the Volcker Rule available to securitizations backed exclusively by loans, and not by bonds or other kinds of securities.

Since the Volcker Rule took effect in 2015, the vast majority of CLOs have put themselves into compliance by eschewing or unloading bonds, although there are other workarounds available.

Among the questions the Fed is now asking is whether regulators should permit "a loan securitization vehicle to hold 5% or 10% of assets that are considered debt securities rather than 'loans.' "

In the past, bonds typically accounted for no more than 5% to 10% of the collateral for CLOs, so such a change would put the market right back where it was before 2015.

It's not the first time a federal agency has contemplated changes to the Volcker Rule that would put bond buckets back in play. A proposal was floated a year ago by the then-acting U.S. comptroller of the currency, Keith Noreika, with the possibility the OCC might act on its own to re-interpret the prop-trading ban.

The new proposal appears to have the backing of OCC as well as other federal regulators, including the SEC, the Federal Deposit Insurance Corp. and the Commodities Futures Trading Commission.

“It seems clear that the agencies are opening up a real debate and consideration” on changes that could allow bond assets which “fit within the constraints of the Volcker Rule," analysts at Deutsche Bank said in a report published Tuesday.

In a May 31 client alert, law firm Cleary Gottlieb stated that the proposed rulemaking “represents a first step toward simplifying and clarifying the Volcker Rule.” It expects each of the regulatory agencies to approve the Fed’s notice “within days.”

Comments can be submitted to the Fed for 60 days following the proposal’s publication in the Federal Register.

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