After coming to a near-halt after the final version of the Volcker Rule was released in mid-December, the primary CLO market has shifted cautiously into low gear, despite the fact that the rules of the road remain unclear.

The collateralized loan obligation market had hoped to escape unscathed, but the rules under Volker prohibit U.S. banks from having an ownership interest in a securitization backed by bonds or other securities.
Three potential outcomes exist to the problem of U.S. banks holding the senior tranches of CLOs that hold bonds, one of which would address the matter for all CLOs, present and future.

And while there is reason for optimism that this best case scenario will come to pass, caution currently rules on the new issue market.

“This is real time for us,” said one CLO manager whose firm is planning to launch a new deal in the near future. “And for the time being, it’s effectively no bonds.”

The key word here is “effectively.”

According to market participants, most new issue CLOs now include wording that allows for future bond holdings if regulators clarify certain Volker Rule language—specifically, whether the right of triple-A investors to replace or remove a manager for cause constitutes an “ownership interest.”

Because the holders of CLO senior notes have manager removal rights, the concern is that triple-A investors will be considered to hold ownership interests under Volcker.

That leaves banks wondering whether they will have to unload their CLO paper—as much as $70 billion of senior notes—before the rule takes effect in 2015.

“For our next transaction, at present the proposed language includes a springing bond bucket which would be utilized only if it is deemed that investments in the debt tranches of the CLO are not considered ‘ownership interests’ as defined in the Volcker Rule,” said John Popp, head of the leveraged investments group at Credit Suisse Asset Management.

Columbia Management Investment Advisers and Black Diamond Capital Management have also recently marketed deals with leeway to change the investment allocation to include bonds in the future, according to rating agency presale reports.

Outcome #1: The Big Fix

The clarification of the ownership interest language is what the Loan Syndications and Trading Association (LSTA) and other trade groups are pushing for. 

“This is a really easy fix as regulatory things go. It could be done in the form of an FAQ or a joint statement by the agencies,” said Elliot Ganz, general counsel for the LSTA. “We’re not asking them to exempt anything. If CLO investors have the right to remove or replace a manager for cause, all we’re asking is that the agencies agree that that doesn’t constitute an ownership interest.”

Moreover, not only does this simple solution solve the problem for all CLOs, it represents reality, Ganz said.

“What the agencies don’t want to have happen is that you have what’s called a debt security, but really it has all these elements of ownership that make it look like an equity,” Ganz said. “We get that, and all we’re saying is the right to remove or replace a manager is not really an ownership interest, it’s a protective provision.”

The good news is that there is bipartisan support in Congress for solving the problem, said Ganz, who testified before the House of Representatives’ Financial Services Committee at a Jan. 15 hearing, where representatives from both parties indicated a willingness to work with regulators.

When this might happen remains, again, unclear.

Outcome #2: Grandfathering

In the meantime, speculation continues around a second possible solution: the exemption, or grandfathering, of existing CLOs. Since regulators decided in December to exempt, from the Volcker Rule, collateralized debt obligations holding trust-preferred securities (Trups CDOs) established before May 19, 2010 and obtained by Dec. 10, 2013, analysts and market participants have theorized that the same could happen with CLOs.

This outcome would be far better than no exemption, however it could create a market bifurcation, with U.S. banks—key triple-A investors—limited to buying new issue CLO paper, or CLO 3.0, while demand for secondary CLO 2.0 paper would be limited to asset managers and others not affected by Volcker. 

If this were to happen, analysts do expect banks to attempt, on a deal-by-deal basis, to work with managers to remove bonds from existing CLOs. However, they would also expect CLO equity holders to push back on this, as bonds can provide value to equity tranche owners, especially during times of volatility, and as assets to purchase just prior to the reinvestment period conclusion.

“Taking away the ability of a manager to invest in other asset classes takes away optionality they’ve traditionally had,” said Kenneth Kroszner, CLO analyst at Royal Bank of Scotland. “It eliminates a way to express relative value between loans and bonds, which could ultimately limit equity returns.”

Market participants agree that if holding bonds remains problematic for new CLOs, managers will deal with the issue of equity returns by buying more second-lien loans. And some believe that the difference between high yield bond returns and second lien returns will be minimal over the next several years, considering where interest rates appear to be headed.  

“We’re in an environment where the expectation is that interest rates will increase over the next five years, it’s just a matter of how much,” said Steven Oh, managing director of global credit and fixed income at PineBridge Investments. “I don’t think we’ll see the same outperformance of high yield bonds going forward that we’ve seen historically. So putting bonds in your portfolio does not necessarily mean you’ll have a better outcome, especially if interest rates rise in a meaningful way.”

CLO managers could face stiff competition for second-lien loans, however. In research published Jan. 31, analysts at Barclays predicted that the imbalance of supply and demand for second-liens to be  “even more extreme” than it will be for first-lien loans.

While some deals cannot own any second liens, many are able to own up to 10%, and the average post-crisis CLO deal has a bucket of 5.5%,” the report stated. “Therefore, similar to the overall loan market, CLOs could own up to half the almost $27 billion second-lien loan market.

The report noted that CLOs have not traditionally allocated as much to second-liens as they could, they are likely to take full use of second-lien buckets if forced to abandon bond holdings as a result of the Volcker Rule’s definition of ownership interest.

Another issue with eliminating bonds has to do with fixed-rate liabilities: some CLOs with big bond buckets issue a tranche of fixed-rate notes, to better match interest payments with cash flow from the collateral. If these CLOs were to divest their bond holdings, there could be a mismatch.

“It’s not a large percentage of the CLOs, but many do have fixed-rate liabilities,” Kroszner said. “Equity holders in these transactions face disproportionately higher funding costs due to the current steepness of the yield curve. Without fixed-rate high yield assets to offset these costs, equity yields may shrink. In addition, there will always be an inherent mismatch between floating collateral and fixed liabilities, which may present its own issues down the line.”

Outcome #3: No Change, Sell-Off Ensues

Of course, the third possible outcome, which now appears to be the least likely, is that regulators choose to do nothing—no language clarification, no grandfathering of existing deals—and banks are forced to divest their CLO holdings. (Even though not all existing CLOs hold bonds, nearly all of them have the ability to, and without control over a manager’s future investment decisions, banks would likely get out entirely.)

Indeed, there was a BWIC that came out within a week of the publication of the final Volcker Rule from a regional bank selling all of its triple-A paper, market participants say.

More of this would be disastrous for the CLO market, both existing and new issue.

As Ganz explained to the congressional committee: The act of selling would put downward pressure on CLO prices and could trigger more selling pressure, potentially causing a downward spiral of falling prices and further sales, all despite no fundamental changes in the projected cash flows of the underlying CLO debt security.

The good news is that lawmakers at least appear to be listening

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