Issuance of U.S. collateralized loan obligations is on the rebound after dipping sharply following the release of the final version of the Volcker Rule.

Collateralized loan obligations have two years to become compliant with the Volcker Rule or lose their biggest investors – banks –  but some CLO managers aren’t wasting any time. They are not only divesting any bonds backing these deals, they are also eliminating the ability to invest in bonds in the future.

The Volcker Rule prohibits banks from having an ownership interest in CLOs backed by anything but loans (and cash equivalents). That’s a problem for most CLOs printed in 2011, 2012 and 2013, which tend to have the ability to invest 5% or 10% in bonds. This qualifies them as a “covered fund” under Volcker. And because banks tend to own the senior debt securities issued by CLOs, which gives them the ability to remove the managers, for cause, they can be considered to have an ownership interest in these deals.

The Federal Reserve has given banks until July 2017, in most cases, to conform their CLO holdings to Volcker. So there is no longer such a sense of urgency in the CLO market. By that date, most deals issued before 2014 will have exited their non-call periods, making it possible to refinance them.  And a refinancing is an opportune time to amend a CLO’s investment restrictions.

Still, some managers aren’t waiting around. In April, Golub Capital Partners CLO 10 entered into a supplemental indenture intended to make it compliant with Volcker by prohibiting investments in non-loan securities, according to Moody’s Investors Service. Moody’s published a report saying that this change in investment criteria did not affect its ‘AAA’ rating on the deal’s senior tranche. (Moody’s does not rate any of the deal’s subordinate tranches.)

The CLO is managed by an affiliate of Golub Capital, a money manager with $10 billion in assets, including a dozen or so CLOs.

“We offered to Volckerize the CLO because we knew that doing so was very important to several of our investors,” said Craig Benton, the firm’s head of structured products. “Volckerizing the deal was consistent with our business philosophy of building strong, win-win partnerships.”

Golub Capital may have fewer hurdles to making its CLOs Volcker-compliant than some other managers, but it is not alone. 

John Timperio, a partner in the structured finance and securitization practice at law firm Dechert, says that he has worked with a number of CLO clients to strip out the ability to invest in bonds; and he expects that more managers will do so. 

CLOs can’t amend their investment criteria without the consent of the holders of the junior-most securities issued by these deals, known as the equity. In all of the deal amendments that Timperio is familiar with, the CLO equity was held by the manager or an affiliate of the manager, making it much easier to reach an agreement.

It is fairly common for managers of middle market CLOs to retain the equity in their deals.  That’s because many of these firms are commercial lenders that securitize loans already on their balance sheet as a means of funding new loans. For example, Golub Capital, which manages CLOs backed by loans to small and medium-sized companies as well as CLOs backed by broadly syndicated loans, is known for holding on to the equity in its deals.

By comparison, managers of CLOs backed by broadly syndicated loans are more typically asset management firms that acquire the collateral for deals in the primary or secondary market. More often than not, they do not have the capability to hold on to large amounts of equity in these deals.

However there are a number of larger managers of CLOs backed by broadly syndicated loans that do hold on to the equity or have an affiliate that holds the equity. Such firms are also in a relatively easy position to amend the investment criteria of their deals. “It cuts across a random group of managers, but the common denominator is affiliates with deep pockets,” Timperio said.

“Obviously, the low hanging fruit was done kind of quickly, but there will be a continued focus on amending more of these as we go along,” he said.

There’s another reason it’s easier for some managers to ditch bonds than others: they aren’t making much use of them. Golub Capital is one such manager; some of its pre-Volcker deals never had the ability to invest in bonds to begin with, according to investors and rating agency reports.

In cases where the CLO equity is held by a third party, and the pool of collateral does include bonds, there is going to be some horse trading.  Removing the bond bucket is unattractive for equity holders, since these securities only receive whatever cash flows are left over after more senior note holders are paid, and bonds are typically among the highest yielding assets in the pool of collateral.

“I’m not sure there’s a market standard” for amending deals in these cases, Timperio said.

Still, the Volcker Rule is no longer the threat to the CLO industry that it was just a few months ago, when it appeared that banks might have to divest billions of dollars of holdings into an illiquid market. This could have forced them to realized big losses by selling the securities at a discount to non-bank investors; it could also have made it more difficult for less credit worthy companies to borrow money, by reducing demand for non-investment grade loans.

After dipping sharply in December 2013, CLO issuance has climbed in each month this year, reaching $11.8 billion in April, bringing issuance for the first four months of the year to $34.1 billion. Since then there has been another $10.8 billion in issuance through May 26, according to Thomson Reuters LPC, for a year-to-date total of $44.9 billion. This represents an increase of nearly 29% over the same period of 2013.

“If regulators were to have suddenly required banks to divest themselves of tens of billions worth of CLO AAAs, you have to ask ‘who’s the bidder for all of that paper?’,” said Keith Ashton, a portfolio manager at Ares Management, one of the largest U.S. CLO managers

“You’re potentially selling into a vacuum,” he said.

“It would be very dislocating if that was the direction regulators were thinking of taking this.  They absolutely needed to be aware that there isn’t sufficient depth to the triple-A CLO market, away from banks, to catch a wholesale liquidation unless it was handled in a very disciplined, patient, orderly process.”

So when the Federal Reserve announced the extension of the deadline to comply in April, “there was a breath of relief out there and the sense of urgency ebbed,” Ashton said. “Most non-compliant CLOs will have ended their non-call periods well before the new 2017 deadline, providing equity holders an opportunity and possibly an economic incentive to refinance. That’s when most deals will handle ‘Volckerization.’”

Now, Ashton said, “there is time for the market to work out a solution, since the life cycle of CLOs will probably accommodate most of this. These extra two years are a fairly thoughtful solution, as most CLOs will be past their non-call periods, or amortized, and so maybe 80% of the potential problem goes away on its own in the normal course.”

Over $45 billion of CLOs exit their non-call periods in 2014; another $98.5 billion do so in 2015, according to Wells Fargo.

“There will probably be some CLOs that don’t get Volckerized for whatever reason, where banks may be compelled to sell that paper, and it will probably trade to insurance companies who will certainly try to charge for the liquidity they provide,” said Ashton.

In addition to managing CLOs, Ares invests in the equity of CLOs run by other management companies, so the firm understands that equity holders look at bonds as a legitimate source of value.

“Bonds can offer relative value from time to time, although maybe not today.  You can use them to pick up higher coupons, or to build par,” Ashton said. “They provide an alternative when you’re not happy with the value or risk available in the second-lien [loan] market.”

It’s not a free lunch. “Bonds present other risks, including lower recoveries.  But in the hands of a competent bond investor, ourselves included, it can add value,” he said.

“No one I know is saying ‘I’m not going to play ball,’ not even the equity guys are squawking. They’re saying, ‘Let’s work something out that makes sense.’  Maybe that means you refinance and achieve a little better debt execution with a compliant structure. In other words, if equity is being asked to abandon something of value on the asset side that improves the liquidity prospects of debt investors, then let’s do something constructive to improve the liability side of the equation.’  Knowing the rational character of most CLO investors, I think the market will find an appropriate balance.” 

There’s more to getting CLOs into compliance than just divesting bonds. Timperio said that, in many cases, managers are also amending CLOs to remove their ability to invest in letters of credit.
“There are differing views as to whether an LOC is a security,” he said. 

Amendments may also tweak the definition of a loan participation agreement, since, depending on the way this agreement is structured, it could be construed as a security.

CLOs are also being amended to redefine what constitutes an acceptable cash equivalent. When cash comes into CLO, say from an interest or principal payment on a loan in the trust, the trustee will park these funds in certain high quality, short-term investments until the manager can use it to purchase additional assets or make interest or principal payments to note holders. 

“Funds can only invest in loans and cash equivalents, so what’s a cash equivalent also comes under scrutiny, in addition to bonds,” Timperio said.

Divesting bonds isn’t the only way to Volckerize CLOs. Banks are also looking at other strategies for getting their holdings into compliance, such as waiving rights that might confer an ownership interest in the deal. “To my knowledge, this hasn’t been pursed on a wide scale yet, but it is a solution we’ve looked into for clients,” Timperio said. “It has some negatives, namely giving up rights to remove manager in situations where there’s a breach for cause.”

It’s also not a sure thing, since regulators have yet to provide specific guidance that waiving rights to remove a manager would result in not having an ownership interest. “A lot of institutions, based on analogous actions by regulators, believe that option is out there,” he said.

A third option for Volckerizing is for CLOs to rely on a different exception to the Investment Company Act of 1940 to avoid registration with the Securities and Exchange Commission than the one used to define a “covered fund” in the Volcker Rule. Most CLOs are issued under an exception allowed by Rule 3c-7 of the Act. (This is the same exception used by many hedge funds and private equity funds and the reason CLOs got ensnared in the Volcker Rule.) But it’s also possible to avoid SEC registration by relying on an exception allowed by Rule 3a-7.

Since CLOs issued under Rule 3a-7 aren’t covered funds, banks can hold the senior debt issued by these vehicles, regardless of their ability to remove the manager or whether the CLOs hold bonds or other securities.

It sounds straightforward, but Rule 3a-7 comes with more restrictions than Rule 3c-7.  Notably, the rule prohibits investment vehicles from making trades for the “primary purpose of recognizing gains or decreasing losses resulting from market value changes.” 

Although most CLOs are actively managed, recognizing gains or avoiding losses isn’t necessarily the primary reason that managers buy or sell assets.  Managers also make trades to comply with various covenants and compliance tests, improve or adjust a deal’s rating profile, diversity score, weighted average life or maturity profile.

So while there are multiple strategies for making CLOs Volcker compliant, Timperio said that “stripping out bond bucket is cleaner, and clearly the one being pursued the most at the moment.”

Given the outsized roles that banks play as investors in the senior securities issued by CLOs, there are ultimately strong incentives for all CLO investors to Volckerize.

“There’s another cost of deals being non-compliant, and not just for triple-A tranches, but for all of the securities issued by the CLO,” Ashton said. “After the deadline passes, [bank] trading desks may become constrained in terms of owning these securities in their inventory.  That suggests they will be more limited in how they make markets in CLOs, and that will likely result in some liquidity discount for non-compliant CLOs.”
Right now, he said, “the CLO market is pretty liquid, pretty deep, and the market isn’t differentiating now between compliant versus non-compliant CLOs in terms of trading levels, except marginally in the triple-A market.

“However, if the market hits an air pocket down the road, that’s likely the time such a liquidity discount could suddenly appear and be material.  Many CLO equity investors also buy debt tranches, so they will also be thinking longer term about Volckerization.  They will need to carefully weigh the value of keeping or giving up the bond bucket not just in terms of raw economics, but also in how they value liquidity.”

This explains why, nearly all of the CLOs issued since the final version of Volcker Rule was passed in December 2013 have had what is known as a “springing” bond bucket: essentially they can only invest in bonds or other  non-loan securities if regulators decide at some date in the future that this no longer runs afoul of Volcker.

By comparison, 67% of all U.S. CLOs had some investments in bonds as of the end of April, according to Thomson Reuters LPC. However, CLOs issued after the financial crisis, which are known collectively as ‘CLO 2.0,’ hold less non-loan assets than ‘CLO 1.0,’ or those issued before the financial crisis. Nearly half, or 47%, of CLO 2.0s have no bond or structured finance holdings versus only 19% of CLO 1.0s.

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