Highland Capital Management LP and Invesco Ltd. have amended their collateralized loan obligations as firms try to get ahead of new rules that would force banks to dump some of their holdings.
U.S. banks own about $70 billion of CLO debt and are prohibited by the U.S. Dodd-Frank Act’s Volcker Rule from owning securities issued by funds that contain bonds. If CLO managers don’t make deals compliant, banks would be forced to dump their holdings, which may result in as much as $9 billion in losses, according to calculations by the Loan Syndications and Trading Association.
There were about $157 billion of CLOs that owned bonds as of June 1, according to Royal Bank of Scotland Group Plc data, and the Federal Reserve said it will give the funds until July 2017 to comply. Some banks, which typically own the highest-rated slices of CLOs, are trying to induce managers to alter the terms of their existing funds by refusing to buy their new ones unless they do, according to Sajid Zaidi, global head of CLO origination and structuring at Morgan Stanley in New York.
Some banks are making amending outstanding transactions a “precondition of investing in new deals for the same manager,” Zaidi said in a telephone interview. “That is giving those managers an incentive to try and get amendments through in order to issue new transactions.”
CLOs pool high-yield, high-risk loans and slice them into securities of varying risk and return. High-yield debt is rated below Baa3 by Moody’s Investors Service and less than BBB- by Standard & Poor’s.
For a typical amendment, the CLO manager and more than half of AAA and equity investors must agree to the changes, Ken Kroszner, head of CLO strategy at RBS in Stamford, Connecticut, said in a telephone interview. Equity holders, who get what’s left over after debt investors are paid, may benefit from the extra return generated by owning bonds, and may be unwilling to agree without getting something in return.
The Clearing House Association LLC, a trade group representing large U.S. banks, has been working on guidelines that may make it easier for CLO managers to amend existing deals to make them compliant, two people with knowledge of the matter said last month.
Dallas-based Highland, which oversees about $18.7 billion, amended its Acis CLO 2013-1 in the first quarter to eliminate the ability to invest in bonds, according to a person with knowledge of the change, who asked not to be identified because the information is private.
Shannon Wherry, a Highland spokeswoman, declined to comment.
Invesco in April amended its Avalon IV Capital CLO as part of a refinancing, according to Joe Rotondo, senior portfolio manager at Invesco, which oversees $30.6 billion in bank loans. Equity holders benefited because interest rates on the CLO’s debt were lowered, he said in a telephone interview.
“It was a very positive event for all investors,” said Rotondo, who is based in New York. “All rated notes were retired at par, and the equity benefits from a lower cost of debt capital.”
The firm cut the interest rate on the deal’s $231 million AAA piece to 117 basis points more than the London interbank offered rate from 150 basis points, he said. A basis point is 0.01 percentage point.
“Right now it’s a hot issue about how to deal with legacy CLOs from a Volcker-compliance standpoint, given the amount of CLO debt held by banking entities,” said Neil Weidner, a partner in New York at law firm Cadwalader, Wickersham & Taft LLP.
If banks have to sell their AAA holdings, losses may range from $1 billion to $9 billion, depending on market conditions, according to LSTA calculations.