While the Volcker Rule gets blamed for the sudden lull in CLO issuance in January and February, it’s now getting some credit for helping one aspect of the roaring comeback of collateralized loan obligations: the infusion of new investors in triple-A tranches.
Since the second quarter of 2013, a litany of asset managers, insurance firms, pension funds and hedge funds have taken over a 42% share of triple-A paper in CLOs, compared with just 10% a year earlier, according to JPMorgan. Meanwhile, banks which largely took a breather from the CLO market when mulling over new federal rules against institutions holding certain CLOs under Volcker Rule prohibitions saw their 90% share of triple-A tranches trickle down to 56% during that same period.
“Banks have had to rethink their strategy and make sure their portfolio is compliant,” said Dave Preston, a CLO and commercial asset-backed analyst for Wells Fargo Securities. “But I think one of the positive outgrowths of that is that there’s been a real expansion of the triple-A investor base beyond just big banks.”
The result has not only been a rush of new CLOs to meet investor demand for high-yield, floating rate assets, but also an increase in the average deal size as firms construct new investment vehicles with as much triple-A paper as possible. Since 2012, according to Wells Fargo, the average CLO portfolio size has grown to $545 million from $410 million.
The new CLOs attract a wide range of investors, despite being constructed without the ability to invest in bonds, whic puts them in compliance with the Volcker Rule. The draw is triple-A tranches with average spreads of 140-150 basis points, exceeding those of triple-A paper in other securitized products like commercial-backed mortgage securities. The fact that they are floating rate has also been attractive in an uncertain rate environment.
Over the last two years, spreads on triple-A tranches have also been much less volatile than spreads in the lower-rated CLO tranches. Two years ago, spreads on double-B-minus rated notes exceeded 400 basis points and spreads on single-B notes exceeded 600 basis points; they have since tightened by 50-150 basis points.
“It’s just fundamentally very attractive, and in this low interest-rate environment, for a safe asset it offers a pretty high spread,” said Matt Natcharian, head of Babson Capital’s structured credit team. “The solid track record, wider spreads and stronger post-crisis structures have combined to expand the investor base.”
“The spread over that floating rate is still dislocated and probably the most attractive feature in a CLO capital structure,” added Josh Terry, head of trading and structured products for Highland Capital Management. “Mainly for the reason that you don’t have as many banks and levered investors participating today.”
CLO issuance is on pace to exceed $100 billion for the year, in market projections by both Wells Fargo and JPMorgan. All the more remarkable is that issuance was at a standstill in January and February after the Federal Reserve interpreted that holding CLOs with bonds would run bank invetors afoul of the Volcker Rule.
The Fed later extended an original 2015 deadline until 2017 for banks to sell or “Volckerize” their CLO holdings by selling off bond-related assets. It was after banks and investors formed strategies around the Volcker Rule that CLO issuance picked up a head of steam. Sixty-five U.S. CLOs totaling nearly $37 billion came to market between April and June, making the most active quarter on record, according to Fitch Ratings.
One problem for investors is that this volume has pressured liabilities, keeping spreads on most tranches of new deals flat “even as most other credit markets (structured and otherwise) continued to rally,” Barclays’ head of credit strategy Bradley Rogoff said in July report. However triple-A tranches are an exeption: “they have moved approximately 5 basis points tighter relative to year-end levels as leveraged buyers have entered the market.”
Wells Fargo noted in a Juen report that triple-A tranches in CLO “2.0s” (those constructed after the crisis) are one of best values in the capital stack for investors, next to high-coupon BBB’/’BB’ tranches and the mezzanine tranches of CLO 1.0 vehicles.
Another factor boosting CLO issuance is the fact that yields on loans used as collateral have risen as loan mutual funds, traditionally another big buyer, have less money to put to work lately. Investors have been withdrawing money from loan funds, meaning CLOs have less competition for these assets. And the higher the yields on loans, the more cashflow there is available to pay interest on CLO notes.
That might have investment banks calling for higher proportions of triple-A paper in their CLOs (such as the 75% level they reached in pre-crisis CLOs). But CLOs are maintaining roughly the same percentage of triple-A paper (between 60-65%) as in recent vintages.
CLO sponsors and arrangers still need to realize an asset-mix and risk appetite in the portfolio for attracting the optimum range of investors. “An investment banker wants to create the most efficient structure based on the demand they’re seeing and the criteria to get the debt rated as highly as possible,” said Natcharian.
