Collateralized loan obligations spent the past three years getting into compliance with the Volcker Rule, which compelled them to divest of any high yield bonds or risk losing their biggest customers – U.S. banks.
Now the acting comptroller of the currency, the nation’s main bank regulator, is suggesting that his agency could reinterpret the rule.
But after going through trouble and expense of getting into compliance with Volcker, would CLO managers even want to put money back to work in bonds?
The short answer appears to be “yes – but not right away.”
“I don’t think the process of Volckerizing existing CLOs was all that pleasant, but that’s mostly run through the system,” Meredith Coffey, executive vice president of the Loan Syndications and Trading Association, said in an email.
“As for the ability to invest in [high yield] bonds in the future, I think managers would generally like that flexibility,” she said. “In reality, allowing a small – 5%-10% – bond bucket can both improve yield and even theoretically reduce volatility in a portfolio. Managers would have expanded diversification opportunities, allowing them to buy more companies, and they can make better relative value decisions between the loans and the bonds of a company.”
It’s not clear that in today’ market managers would necessarily buy more bonds, since the relative value may favor loans. However, "having that option in the future seems like a clear win to me,” Coffey said.
Keith Noreika, who became acting comptroller of the currency just three days
An OCC spokesman speaking to American Banker, a sister publication of Asset Securitization Report, appeared to suggest Noreika was not contemplating having the agency write its own rule, but alter how it enforces the existing one.
CLOs issue securities and use the proceeds to acquire portfolios of below-investment grade corporate loans. Historically, managers of these deals also invested in relatively small amounts of high yield bonds, in part to juice returns. High yield bonds offer exposure to many of the same companies, but typically yield more, because they are riskier.
That changed when the Volcker Rule took effect, prohibiting banks from engaging in proprietary trading and, as a corollary, from acquiring or retaining any ownership interest in a hedge fund or private equity fund, identified as a "covered fund" under agency regulations. CLOs that hold high yield bonds or other kinds of securities, essentially anything other than loans, are generally the definition of a covered fund. This meant CLOs had to divest their bond holdings, or risk losing some of their biggest investors.
“The agency has authority to issue guidance and examination procedures independently to clarify what’s in a rule wherever clarification may be needed," the spokesman said.
Deborah Festa, a partner at law firm Milbank, noted that the impact of Volcker Rule was felt most by investors in the most subordinate tranches of notes issued by CLOs, known as the equity. Holders of these securities are entitled to whatever funds are left over after interest and principal is paid on more senior securities.
“Many of the large banks that hold the triple-A positions in a lot of these deals went back and pressured managers to amend their transactions to become compliant with the loan securitization exemption...which of course meant complicated negotiations with some investors to try to get them to consent to the amendments, do a supplemental indenture, work with the ratings agencies,” Festa said. “So there was a cost absorbed by some of the deals that had to do that.”
Many CLOs divested bondholding during a refinancing boom that started in the second quarter of 2014. Of $11.9 billion of deals that were amended to lower interest rates during that the initial conformance period through the second quarter of 2015, all but two, totaling $771 million, were also brought into compliance with Volcker.
In exchange, some equity investors negotiated new supplemental indentures designed to protect their cash flow. According to a report published by Wells Fargo in 2015, these concessions included higher concentration limits for loans with few restrictive covenants and relief from weighted average life tests that slowed amortization (and preserved interest flow).
Festa said the real question is whether investors would be comfortable with CLOs that hold bonds.
“Unlike the risk retention rules, where if you violate them it’s an Exchange Act violation on behalf of the manager, with the Volcker Rule there’s no hard and fast obligation on the manager,” Festa said. “The only question is, can you sell the bonds?”
She said the general counsels of the major banks would likely want to see more formal action by the regulators or Congress before they get comfortable.
