The business of bundling junk-rated corporate loans into top-rated securities is booming like never before following the implementation of regulation aimed at making the financial system safer.
More than $46 billion of collateralized loan obligations have been raised this year in the U.S. through the end of May, after $82 billion were sold in all of 2013, according to Royal Bank of Scotland Group Plc. JPMorgan Chase & Co. boosted its annual forecast to as much as $100 billion, which means 2014 may end up as the biggest year on record, while Onex Corp. said yesterday it will expand its CLO business.
Issuance of CLOs, which helped finance some of the biggest leveraged buyouts in history during the last credit boom, has picked up following an early 2014 slump brought on by the publication of the Volcker Rule designed to limit risk-taking by banks -- major buyers of the funds. CLOs are investors in speculative-grade loans, an asset class in which U.S. banking regulators have said underwriting standards have become too lax.
“It has been an extraordinary run; the market has been on a tear,” said Oliver Wriedt, co-president of CIFC Corp. in New York, which oversees about $12.3 billion. There is a lot of interest in investing in the most senior portions of CLOs, he said in a telephone interview.
CLO sales plunged to $2.55 billion in January, the least since July 2012, according to RBS, following the December publication of the final draft of the Volcker Rule. The rule prohibits banks from investing in the debt of CLOs that own bonds. After the market developed funds that adhered to the regulation, sales rebounded in February with $9.4 billion raised that month, RBS data show.
“Volcker was clearly a huge headwind in December and January as managers and investors waited for clarification and further understanding of the rule,” Ken Kroszner, head of CLO strategy at RBS in Stamford, Connecticut, said in a telephone interview.
The credit investment unit of Onex, Canada’s biggest buyout firm, will seek to triple its assets under management to $10 billion by the end of 2017, from $3.3 billion in 2013. Onex Credit Partners LLC raised a $1 billion CLO last month, the largest deal this year.
“As this investing platform continues to grow, so too will the recurring management fees it generates, and that of course creates additional value for Onex shareholders,” Gerald Schwartz, the company’s chief executive officer, said on a May 16 earnings call. “We continue to believe these CLOs are an attractive opportunity for us to invest some of our cash.”
CLOs pool high-yield corporate loans and slice them 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 returns and the greatest risk because investors are the first to see their interest payouts reduced when loans backing the CLO default.
CLO managers may also be trying to issue deals ahead of risk-retention rules proposed by the Dodd-Frank Act in order to increase assets under management and income, said Kroszner. The regulation may require CLO managers to hold 5 percent of the debt they package or sell.
The proposed regulation should take into account that CLOs bundle senior-ranking borrowings, which are less risky than debt repackaged by other securitizations, according to the Loan Syndications and Trading Association, a New York-based trade group.
Out of 719 U.S. CLOs that purchased widely syndicated loans and were rated by Moody’s Investors Service between January 1996 and May 2012, only 14 funds lost any of their principal at maturity, according to a July 2012 report from the ratings firm.
The deadline to comment to banking regulators on the risk-retention rules was last October.
JPMorgan, which raised its forecast from as much as $70 billion, isn’t alone.
Wells Fargo & Co., the San Francisco-based lender, increased its 2014 prediction to as much as $90 billion in April from an original estimate of $60 billion. Morgan Stanley boosted its call to a high of $85 billion last month from $65 billion.
“The pending threat of risk retention has fueled the CLO-issuance fire,” said Wriedt. “Everyone has been highly motivated to come to market, which is why we are seeing such a plethora of deals.”
GSO Capital Partners LP, the credit unit of Blackstone Group LP, raised two U.S. deals this year, the most recent a $717.4 million fund in May, according to Bloomberg data. Sankaty Advisors LLC, the debt-investing group of Bain Capital LLC, raised a $727.5 million CLO in March.
CLOs were the biggest buyers of junk-rated loans in the first quarter with 58 percent market share, the most since 2006 when they had a 61 percent share, according to a report from the LSTA, citing Standard & Poor’s Capital IQ Leveraged Commentary and Data. Retail funds came in second at 26 percent.
The deals helped propel issuance of new leveraged loans to $357 billion in 2013, the most on record, Bloomberg data show. There have been $145.5 billion of new loans issued in the U.S. this year.
The growth in riskier corporate lending led the Federal Reserve and the Office of the Comptroller of the Currency to warn lenders last year to improve lax underwriting practices. Todd Vermilyea, a Fed official, said May 13 that standards “have continued to deteriorate in 2014” and that “stronger supervisory action” may be needed.
While the Volcker Rule hasn’t led to fewer CLOs it has kept the cost to raise the funds elevated.
The average rate paid on CLO portions ranked AAA was about 150 basis points more than the London interbank offered rate in May, according to Wells Fargo. That’s up from a spread as low as 110 basis points on AAA slices last year.
“New regulations, especially the Volcker Rule, have had a significant impact on banks’ participation in this market and is the primary reason CLO AAA” spreads remain wide, Matthew Natcharian, head of the structured credit team at Babson Capital Management LLC in Springfield, Massachusetts, wrote in an e-mail.
To be Volcker compliant, managers are primarily choosing to issue CLOs that are prohibited from owning bonds or can only purchase the debt at a later date if the stipulation is changed.
The Fed said it intends to give banks an additional two years to abide by Volcker, pushing the conformance deadline to July 21, 2017, according to an April 7 statement. U.S. banks own about $70 billion of the debt, according to the LSTA.
The monthly pace of CLO issuance might not “keep up for the rest of the year, but for the two most important parts of a capital structure, AAAs and equity, demand should remain robust,” RBS’ Kroszner said.