CLO investing in an evolving regulatory environment discussed

Representatives from Thomson Reuters, Prudential Fixed Income and Guggenheim Securities discussed the CLO investment landscape in an evolving regulatory environment during a live webinar hosted by SCI last month (view the webinar here). Topics included the impact of risk retention requirements and the Volcker Rule, as well as current drivers of relative value. This Q&A article highlights some of the main talking points from the session.

Q: How has the regulatory environment impacted new issue volumes and secondary supply?
A: Matthew Rose, head of CLO pricing at Thomson Reuters: The US CLO new issue market started the year off slowly, with just US$2.6bn priced in January, compared to US$4.4bn in December while the market awaited clarity on the Volcker Rule. Since then, volume has picked up strongly, with US$8.4bn issued in February and US$10.8bn in March as the market begins to implement structural alternatives that are Volcker-compliant.

Although geo-political events caused a slow-down in secondary markets earlier in the year, BWIC activity has also picked up recently, focusing on US and European senior bonds with shorter average lives. Also making the headlines is the refinancing of CLO 2.0 deals as 2012-vintage transactions exit their non-call periods.

Mario Verna, md at Guggenheim Securities: Some players are predicting full-year issuance of US$55bn in 2014, compared to US$85bn last year, which sounds somewhat pessimistic - especially considering the run-rate we've seen so far, albeit at a compressed arbitrage. There is an active pipeline, especially later on in the year when the number of transactions expected to be refinanced spikes.

Q: How are spreads likely to react if the regulatory uncertainty lifts?
A: Verna: If the situation is resolved with a positive outcome, triple-A CLO spreads at least in the US are likely to tighten by 10bp-15bp, as there will be less pressure for banks to divest their triple-A rated holdings. Mezzanine bonds probably won't come in that much because they've already seen significant tightening.

There are no fundamental reasons for spreads to tighten by more than 10bp-15bp. However, we've seen different investors entering the market to take advantage of repo financing - for example, repoing triple-A and triple-B bonds by putting up a 20% margin. More investors results in more capacity, which tends to drive rates lower.

Indeed, insurance companies are increasingly participating in US managed CLOs and now account for around 30% of the buyer base, compared to 10% previously. These players seem to be filling in many of the gaps that the banks have left, although some large US banks have indicated that they're looking to get back into the market.

We're also seeing a rise in warehouse providers entering the sector, which is indicative of the drive in the market a present. Warehouse terms are now more advantageous to the borrower, typically featuring longer terms, with fewer market value triggers or perhaps no market value triggers.

CLOs remain an attractive alternative to other asset classes, such as investment grade bonds and CMBS, which trade about 60bp-65bp tighter.

It remains to be seen what impact the Volcker Rule will have, if any, on loan spreads. While Volcker may not have a direct impact, Fed action more generally will.

If rates rise within the next year, as many expect, the beneficial effect of the Libor floor will diminish. However, in a rising interest rate environment, floating rate product is advantageous.

Q: What are the latest developments with respect to the skin-in-the-game debate?
A: Rose: The risk retention requirement under Dodd-Frank allows for the exemption of CLO-eligible loan tranches, where the lead arranger agrees to retain 5% of the entire notional tranche. They would be prohibited from selling or hedging the exposure for the life of the transaction. But this arrangement seems unworkable for banks, which face new capital restrictions.

The LSTA has introduced an alternative concept - the 'qualified CLO' - which would be subject to six criteria around asset quality, portfolio composition, structural protection, alignment of interest between managers and investors, transparency and disclosure, and regulatory oversight. If a CLO were to meet all these criteria, then the manager could meet the risk retention requirements by holding 5% of just the equity tranche, rather than 5% of the entire deal.

One of the key points to remember here is that - unlike other securitised products - CLOs are not originate-to-distribute deals, but are diversified credit portfolios that are actively managed by asset managers, most of whom are registered advisors.

Edwin Wilches, senior associate and portfolio manager at Prudential Fixed Income: Not being an originate-to-distribute product, it's unfortunate that CLOs have been caught up in the broader effort to address the shortcomings of structured products. The qualified CLO route is a positive step forward for the industry, as a 5% vertical slice would be quite cumbersome for many managers to retain.

Verna: The LSTA has been vocal about alignment of interest occurring through the subordinate fee structure for managers, but somewhat surprisingly this hasn't been met with a lot of enthusiasm from the regulators. They seem unconvinced that this would provide enough alignment of interest, despite managers being incentivised to manage CLOs properly with respect to investor interests. Risk retention is necessary in any structured transaction, but the point that the industry is trying to make is that such alignment exists by virtue of the manager's fee structure.

The fixes suggested so far aren't ideal; for example, the open market approach where banks retain the risk goes counter to the need for them to syndicate the risk. And the qualifying loan proposal seems to be more suited to MBS. It's frustrating that, despite all of the industry's efforts, there is still a lot of discussion around how risk retention requirements will play out.

Q: Continuing the risk retention theme, how is the implementation of CRD Article 122a progressing in Europe?
A: Verna: Article 122a has been in effect in Europe since January 2011 and was revised in May 2013 to the Capital Requirements Regulation. Under the CRR, the 5% risk retention needs to be held by one of three participants - the originator, the sponsor or the original lender. The burden of proof is on the investor.

CLO volume in Europe picked up in the second half of 2013. In most issuances, the sponsor was a large manager that was able to finance the risk retention piece itself. But this would be a significant burden for smaller managers.

One change that occurred in December allows US managers to qualify as the risk retention provider; previously only EU or MiFID institutions could qualify. The definition was revised to allow any manager of a securitisation programme to qualify.

Under the revision, the originator purchases the loans for its own account and sells them to the CLO or otherwise securitises them. This also provides for other investors in the capital structure to qualify.

Article 122a seems to offer more flexibility than Dodd-Frank; for example, it allows a participant to further leverage/finance the vertical slice. A manager can, for instance, borrow 80% say against the 5% - effectively creating an equity-like return. However, the 80% financed also needs to be retained for the life of the deal, thereby satisfying the 5% requirement.

This probably applies more to the US, but if the 5% needs to strictly be held by a manager, the risk is that there will be a further consolidation of asset managers and ultimately a reduction in issuance and funding for corporates.

Q: The passage last month of the Barr bill shows that there is broad bipartisan support for relief for CLOs under the Volcker Rule. This was followed by the regulatory agencies announcing an extension of the compliance period until 21 July 2017. Where do these developments leave CLO market participants?
A: Wilches: The Barr bill was a little mixed. Although it demonstrated the House's agreement on the importance of CLOs, much of the original grandfathering language was eliminated from the bill to achieve bipartisan support.

But I believe grandfathering remains the number one issue. US banks hold an estimated US$75bn of legacy CLOs, while Asian accounts hold another US$25bn-US$50bn. What happens to these portfolios now remains to be seen - I think this is what is really keeping spreads back.

The Barr bill has addressed some market concerns with regards to the 'ownership interest' definition, however, CLO 3.0 transactions are doing a good job of complying with the ownership interest piece and there is a place for the market to exist just by doing loan securitisations.

Ultimately banks have a few options available to them. One option - and we're already seeing this being implemented - is for them to waive the right to replace managers under certain outcomes.

If this is something that their credit departments will not allow or the bank is unwilling to accept, it's difficult to see how deals can be amended. In these cases, when the call periods come up, banks may take a lower spread to where the market is just to get a fix and make the transaction Volcker-compliant retrospectively.

Verna: It's doubtful that other types of investors could fully replace banks if they were precluded from the CLO market entirely. But this is an extreme scenario, since banks can give up control language to make deals compliant.

The type of exemption used under the investment act - whether it's 3c7 or 3a7 - also dictates whether a CLO respectively falls under or is exempt from Volcker. Historically, most deals were done under 3c7, which allows for active trading of the underlying loans. But 3a7 deals have been done by managers that are comfortable with a somewhat more restrictive trading covenant. It depends on the intention and style of the asset manager.

Q: How are managers compensating for the loss of spread from eliminating bond buckets?
A: Wilches: Managers are compensating for the loss of bond buckets in a variety of ways. The natural place to look for extra juice outside of bonds is in second-lien loans. An alternative is to move down in liquidity by looking at smaller facility sizes.

Equity has also capitulated a bit on the required return, while management and dealer fees have compressed. Credit enhancement in many pre-Volcker CLOs is in the high-30%/low-40% range, but - given the lack of bond buckets - rating agencies are allowing managers to lever some of the more recent deals a little more, so that credit enhancement now stands at around 35%.

Verna: Eliminating bonds doesn't seem to have impacted many managers. Across all CLOs, the bond bucket was only utilised to the extent of 1.2%-1.5% of the traditional 10% for US deals. The figure is higher for European transactions, at 9.7%.

Many managers are including second-lien loans, but they have lower recoveries, so cushions need to be added with respect to the rating agency test. We're seeing other managers raising financing privately or via managed accounts as a way to earn fees and increase AUM, and either retaining the equity or syndicating it. This is a way of effectively creating the economics of a CLO, potentially with less regulatory impact.

Other financings are done almost as an extension of the warehouse facility, with the senior lender providing a TRS, for instance. It remains unclear whether these transactions are really CLOs and therefore should fall under Volcker.

Q: In terms of relative value, which factors influence investment in middle market versus broadly syndicated loan CLOs?
A: Verna: Middle market deals represent a strong relative value proposition. A middle market loan is generally made to a US$50m EBITDA company and the facility sizes tend to be US$150m or lower.

Yields tend to be higher than for broadly syndicated loans, at around 535bp margin, with a higher Libor floor. For equity providers, the returns tend to be one point higher than for broadly syndicated CLOs.

Middle market loans also tend to be less levered, while covenants tend to be stricter and historical recovery and default rates have been more advantageous. Structures usually result in higher credit enhancement due to the rating agency assumptions around recovery rates.

Middle market CLO debt trades around 25% wider than broadly syndicated loan CLO debt. There is a fair amount of liquidity for these deals in the secondary market, but not as much as for broadly syndicated loan CLOs.

We're expecting around US$15bn of middle market CLO issuance this year, up from US$11bn last year. Growth is being driven by BDC originations, as well as new money coming into the sector.

Wilches: I think broadly syndicated loan CLO triple-A and double-A bonds are cheap relative to the risk. Based on underlying loan spreads of 350bp-375bp and CLOs yielding 150bp-160bp, the spread capture of 35%-50% is significant, considering the credit risk-remote nature of the deals.

The floating rate nature of broadly syndicated loan CLOs means that they are more attractive to banks than insurance companies or pension funds. I would expect there to be a floor to spreads until a deeper investor base emerges or a mechanism is developed that makes CLOs more attractive to fixed-rate buyers.

Q: How do European and US spread levels compare for CLO 2.0 deals?
A: Verna: European spreads are tighter at the triple-A level. But this is difficult to justify, given that there is less liquidity and less collateral available.

Wilches: European spreads are tighter on a nominal basis and is likely due to the scarcity value, given the paucity of supply. That being said, when buying a US CLO, there is a loss of spread for European-based investors when the cross-currency swap is executed.

Q: How significant is manager style when analysing CLO investments?
A: Wilches: Assessing a CLO manager is one of the first screens we make, in order to ascertain their character, as well as their style. If those two aspects don't match up for us, we won't be able to get comfortable with the structure.

In terms of character, the past actions of a manager and their interpretation of the indenture are paramount because it shows how they treat amend-to-extends and long-dated buckets and so on. This is very indicative of potential future action.

Another important factor is franchise value and how much CLO managers are willing to put at risk to eke out extra returns to the potential detriment of debt holders. The depth of the team is another factor.

Initial portfolios are telling in terms of what a manager intends to do - albeit we understand that underwriting on day one is challenging, given the revolving nature of the pools. Our general philosophy is high quality, high yield investing, so we tend to focus on managers who fulfil that requirement.

Q: How have CLO calls, refinancings and repricings impacted the market?
A: Wilches: CLO refinancings have been healthy for the market in the sense that investors in the refinanced tranches are typically new accounts coming into the asset class, such as managed short-duration or floating rate funds. One interesting technical is that the term structure of triple-As has become clearer: anything with a WAL of under 3.5-4 years is eligible for these funds. Investors are almost rolling their deals and perhaps losing a few basis points in coupon, but receiving an extra two years of call protection.

Verna: Refinancings are mainly driven by equity investors, who can achieve a pick-up of a point or 1.5 points. I expect this trend to accelerate further as spread compression continues.

Rose: We're seeing a lot of focus on refinancings in the secondary market, where there appears to be sensitivity to trading as deals approach the end of their non-call periods. Investors buying into the refis seem to be attracted to the short duration and seasoned portfolios on offer.

Q: How should investors approach tail risk in CLO portfolios?
A: Wilches: Tail risk is a function of a deal's vintage and the opportunities a manager has to buy into the credit market as we move deeper into the cycle. Tail risk will vary depending on a manager's philosophy and risk appetite. The one potential unintended consequence of the past cycle and the recovery post-crisis is that it has emboldened some managers to take more risk than is appropriate.

Verna: TRS and market value triggers exacerbated the losses in the downturn. As fewer triggers are out-of-the-money now, there is less pressure on worst-case scenarios. This, in turn, opens up the possibility for managers to roll into new deals or refinance through a different facility with a portfolio that has a shorter remaining duration and is presumably less levered.