Wall Street Props CLO Boom as Rules Lift Costs: Credit Markets

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A trader works on the floor of the New York Stock Exchange (NYSE) in New York. Photographer: Scott Eells/Bloomberg

The biggest year for collateralized loan obligations since 2007 is being propped up by deals managed by Blackstone Group LP and Carlyle Group LP, which started funds that pledge to boost interest rates to entice buyers.

While $87 billion of CLOs have been issued globally this year based on JPMorgan Chase & Co. data, coupons on the highest-rated portions have risen to as much as 1.5 percentage points over the benchmark from at least a three-year low of 1.1 percentage points in May. Yields rose as GSO Capital Partners LP, the credit arm of Blackstone, Carlyle and other money managers sold at least $4.5 billion of CLOs with the promise of higher interest payments, typically after 18 months.

Money managers and banks are finding new ways to ensure investors keep buying CLOs -- which bundle junk-rated loans used to back buyouts -- after the Federal Deposit Insurance Corp. asked lenders in April to designate AAA rated portions of the notes as “higher-risk” assets. Regulators are now considering more rules targeting the funds, which helped push issuance of leveraged loans this year to a record $277.1 billion, according to data compiled by Bloomberg.

“AAAs continue to be the hardest to sell and banks have become creative in order to distribute the debt,” Ken Kroszner, a Stamford, Connecticut-based CLO analyst at Royal Bank of Scotland Group Plc, said in a telephone interview. At least 10 CLOs sold since June offered a so-called step-up coupon, where rates increase over the life of the deal, according to Kroszner.

CLO Regulations

The Federal Reserve, the Office of the Comptroller of the Currency, the FDIC and the Securities and Exchange Commission, are considering rules, as part of the financial overhaul mandated by the Dodd-Frank Act, that may force banks to hold onto portions of debt they sell to CLOs.

CLO debt buyers, particularly banks, are pulling back as the FDIC ruling requires that lenders with more than $10 billion in assets face a higher assessment rate on those investments, John Fraser, managing partner at 3i Debt Management U.S., the U.S. debt investment arm of London-based buyout firm 3i Group Plc, said in a telephone interview.

CLOs purchase speculative-grade loans and package them into securities of varying risk and return, typically from AAA ratings down to B. While the highest-rated portion are the largest part of CLOs, the lowest, known as the equity tranche, offers the biggest potential return and the greatest risk.

Investors ‘Pause’

“Wherever you are on the globe, the number of regulations coming down the pike that affect CLOs may give investors a little bit of a pause to see how” they affect the market, Dave Preston, an analyst at Wells Fargo & Co. in Charlotte, North Carolina, said in a telephone interview.

Elsewhere in credit markets, the cost to protect against losses on U.S. corporate bonds rose. The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, increased 0.5 basis point to 68.5 basis points as of 10:37 a.m. in New York, according to prices compiled by Bloomberg. The index has declined from 84.5 on Oct. 8, a three-month high.

Swap Spreads

The indexes typically rises as investor confidence deteriorates and falls as it improves. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt-market stress, fell 1.4 basis point to 8.5 basis points. The gauge narrows when investors favor assets such as corporate debt and widens when they seek the perceived safety of government securities.

The Standard & Poor’s/LSTA U.S. Leveraged Loan 100 Index, which tracks the 100 largest dollar-denominated first-lien leveraged loans, was unchanged yesterday at 98.2 cents on the dollar. The debt, which reached an almost six-year high of 98.88 cents in May, has returned 4.57 percent this year.

Leveraged loans and high-yield, high-risk bonds are rated below Baa3 by Moody’s and lower than BBB- at S&P.

Blackstone’s GSO raised a CLO in July that includes a portion in which interest rates increase over the life of the fund, Bloomberg data show. The coupon paid on the AAA portion of the fund rises by 50 basis points to 150 basis points more than Libor after 18 months and increases to 175 basis points 12 months after that.

Carlyle Group was the first manager to issue a CLO with this provision in a $517 million deal it raised in June, according to RBS. It raised a second deal in October that also included this term.

Carlyle CLO

“We are always seeking innovative approaches that meet the needs of our investors,” Justin Plouffe, a principal at Washington-based Carlyle Group focusing on structured corporate credit investments, said in an e-mailed statement. “In this case we felt that the step-up structure balanced a number of specific investor goals.”

Christine Anderson, a GSO spokeswoman, declined to comment. GSO is the largest CLO manager globally, with $16.6 billion as of June 30, according to a July 31 Moody’s report. Carlyle Group is the second biggest, holding $15.7 billion.

While the debt was sold with the intention of being refinanced before the higher rates go into effect, the step-up was included to attract investors seeking shorter-dated debt, according to Kroszner. If the fund can’t be refinanced, the holders receive a higher coupon to make up for still owning the deal.

“The idea was to shorten duration, but if that didn’t work out, the holder would at least be compensated with a higher coupon spread,” Kroszner said.

New Phenomenon

The step-up coupon provision didn’t exist in deals issued before 2008, according to Moody’s. Since no CLOs with this term were raised prior to this year, no manager was forced to consider whether to refinance or pay lenders the higher interest rate.

Spreads on AAA CLO debt have increased the last six months after dropping to at least a three-year low of 110 basis points in May from 145 basis points in January, according to Bloomberg data. Citigroup Inc. raised a $697.7 million CLO for Babson Capital Management LLC last week that includes a $415 million AAA that pays a rate of 148 basis points more than Libor, Bloomberg data show.

CLOs were the largest buyers of leveraged loans with a 53 percent market share in the second quarter, down from 60 percent in the first quarter, according to a report from the Loan Syndications and Trading Association citing data from S&P’s Capital IQ Leveraged Commentary and Data. Mutual funds came in second at 33 percent.

Fixed-Rate AAAs

In addition to offering higher coupons, money managers are also selling fixed-rate CLO bonds and portions that offer better protection to investors. Fixed-rate senior debt may offer a higher-yielding investment compared to a floating-rate AAA slice that is based off three-month Libor, which has been less than 25 basis points since Nov. 1, RBS’s Kroszner said.

Since Aug. 2 there have been $7.3 billion of CLOs sold with fixed-rate AAA slices, according to RBS data. 3i Group raised a deal this month that includes a fixed-rate AAA piece, according to a person familiar with the offering, who asked not to be named because the terms are private.

“There are some investors who can’t invest in floaters or doesn’t want to invest in floaters, and if they can get a fixed-rate AAA, they are very attracted to that,” said 3i’s Fraser, who oversees $3.2 billion in New York. He declined to comment on any 3i deals.

Super-Senior

Money managers are also slicing up AAA rated CLO portions by carving out pieces that offer more credit protection than a so-called mezzanine AAA slice, according to RBS. The senior portion offers extra security because it gets paid interest and principal before, and takes losses after the lower ranking AAA piece. It is sold to attract investors seeking additional ratings protection.

There have been $2.7 billion of CLOs that included super-senior AAA pieces this year, according to RBS data. Five of those funds have been completed since July 19. Saranac Management issued a $351.4 million deal this month with Jefferies Group LLC that included a super-senior structure, according to RBS.

Richard Khaleel, a Jefferies spokesman, didn’t reply to an e-mail seeking comment. Anthony Clemente, Canaras Capital Management LLC’s chief executive officer who is overseeing the deal, declined to comment.

“The most concern has been around the AAA level of the capital structure,” Fraser said. Next year “I don’t see AAA spreads compressing dramatically, but I do see getting a CLO to price being a little bit easier.”

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