Volcker Rule CLOs Emerge as Issuance Plunges 60%: Credit Markets

The Volcker Rule, aimed at making the financial system safer, is already prompting changes in the high-risk corporate loans market even as regulators spar over how to implement the measure without stunting economic growth.

Leon Black’s Apollo Global Management LLC and Highland Capital Management LP recently created collateralized loan obligations that won’t hold bonds to comply with the new regulations, according to four people with knowledge of the matter. Under the rules, banks can’t buy the debt of CLOs that own bonds.

The rules, which were published in a final draft on Dec. 10, are raising concern that the market for CLOs may wilt, cutting off financing to borrowers that may otherwise not have access to capital. Sales of CLOs plunged 60 percent last month to $2.55 billion, the least since $2.2 billion were issued in July 2012, according to Royal Bank of Scotland Group Plc.

“There is some clarification that needs to come,” Frederick Haddad, a partner at GoldenTree Asset Management, which oversees more than $19 billion, said in a telephone interview. “U.S. banks and foreign banks with U.S. operations need to assess what this means for them, and this is keeping them out of the market at the moment.”

Unintended Consequences

Concerns expressed by U.S. lawmakers about possible uneven implementation of the Volcker Rule prompted Federal Reserve Governor Daniel Tarullo to say yesterday that regulators will assess any unintended consequences of the proposed controls.

Banks, which currently own about $70 billion of CLO debt, may be prohibited by Volcker from investing in the funds and forced to sell their holdings. Demand from CLOs contributed to the record $232 billion of new leveraged-loans purchased by non-bank lenders such as CLOs and hedge funds.

“It just throws a monkey wrench of uncertainty into the market,” Haddad said.

Sales of CLOs jumped to $81.6 billion last year from $55.2 billion in 2012, according to RBS. The market had been staging a comeback since 2009, when issuance dried up following the collapse of Lehman Brothers Holdings Inc.

Spreads on top-rated debt of existing CLOs fell to 110 basis points in December from a 2013 high of 130 basis points during the first quarter, according to Morgan Stanley. They rose to as high as 725 basis points in April 2009.

FDIC Rule

A restriction was put in place by the Federal Deposit Insurance Corp. on April 1 requiring banks with more than $10 billion in assets that buy CLOs to designate them as “higher-risk” holdings. Anticipating that, CLO managers rushed to create funds before the proposal took effect, with March sales reaching $10.7 billion, the most in 2013, according to RBS.

U.S. and foreign banks own about 70 percent of outstanding AAA rated portions of CLOs, the largest pieces of the funds, based on a report by consulting firm Oliver Wyman commissioned by the New York-based Loan Syndications and Trading Association.

CLOs package speculative-grade loans into securities of varying risk and return, typically from AAA ratings down to BB. The lowest portion, known as the equity tranche, offers the highest potential return and the greatest risk because investors are the first to see their interest payouts reduced when loans backing the CLO default.

In addition to the FDIC restriction and the Volcker Rule, U.S. banking regulators are considering requiring CLO managers to hold 5 percent of the debt they package or sell as part of implementing Dodd-Frank. The so-called risk retention rule may also force banks to hold onto a portion of a loan they arrange and sell to CLOs without the ability to hedge or offload it.

Reduced Forecast

Morgan Stanley cut its CLO issuance forecast for this year to $55 billion to $65 billion, from as much as $75 billion because of the Volcker Rule.

“The most notable aspect of the CLO market has been lackluster new issuance year-to-date, driven mainly by Volcker Rule uncertainties,” Morgan Stanley analysts led by Vishwanath Tirupattur wrote in a report published yesterday. Sales will remain sluggish until there is legislative relief or there is more clarity regarding compliance, they wrote.

U.S. lawmakers said the formation of a coordinating panel by top financial regulators won’t be enough to avoid uneven implementation of the Volcker Rule.

The criticism at a House Financial Services Committee hearing yesterday came as top officials from the Fed, the FDIC and three other agencies outlined plans for an interagency group in statements for the committee.

‘Top’ Priority

Fed Governor Tarullo said at yesterday’s hearing that the proposed treatment of CLOs is “already at the top” of the interagency group’s agenda. Distinctions between which securities can be included in a CLO under the rule could be worked out in the implementation, he said.

Apollo, the New York-based private-equity firm, priced a $710.8 million CLO on Dec. 20 through Citigroup Inc. and Bank of America Corp. that eliminated the ability to invest in bonds, according to a person familiar with the deal, who asked not to be identified because the information is private.

Highland, a Dallas-based investment manager, removed a similar option to buy notes and Treasuries from a $416.8 million CLO it created last month with the help of Jefferies Group LLC, said a person with knowledge of that transaction.

CVC Fund

CVC Credit Partners LLC, a unit of private-equity firm CVC Capital Partners Ltd., raised a $625 million CLO with the help of Credit Suisse Group AG that priced in November and closed in January that will also be in compliance with the rule, the people said.

Allison Gunther, a spokeswoman for CVC at Brunswick Group LLC, and Charles Zehren, a spokesman for Apollo at Rubenstein Associates, declined to comment. Shannon Wherry, a Highland spokeswoman, also declined to comment.

RBS estimates that 64 percent of outstanding CLOs hold bonds and almost all allow for the debt to be purchased.

“The real uncertainty is how legacy CLOs will be treated and whether banks can hold them or whether they have to sell them, and if they sell them, prices will go down,” said GoldenTree’s Haddad, who is based in New York. “Banks are wrestling with that now.”

AAA Holdings

Banks may be compelled to sell their existing AAA holdings, which may reduce prices and lead to further sales, Elliot Ganz, general counsel at the LSTA, said in Jan. 15 testimony before the House Financial Services Committee.

“The final rule, as written, would cause banks to recognize significant losses on otherwise safe, high-quality assets, which furthers no regulatory objective,” he said.

If the option to buy bonds is removed, CLO managers may seek to increase their investments in second-lien loans in order to increase their returns. The average spread on second-lien borrowings in December was 8.125 percentage points more than the London interbank offered rate, versus 3.696 points for first-lien bank debt, according to Standard & Poor’s Capital IQ Leveraged Commentary and Data.

“There may be some pushback because they are not as liquid as bonds and not as many are available, but this may be an alternative,” Tirupattur of Morgan Stanley, said in a telephone interview.

To contact the reporter on this story: Kristen Haunss in New York at khaunss@bloomberg.net

To contact the editor responsible for this story: Faris Khan at fkhan33@bloomberg.net

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