In the US, the issuance of collateralized loan obligations (CLOs) topped US$64.3 billion in the first half of 2019, a strong showing and only a 5% fall on H1 2018, which was a record-breaking year for the asset class.
The rationale for investors is clear: interest rates remain historically low and look set to fall further in the US and Europe, meaning that safe-haven treasury bonds are offering negligible returns. Investors are therefore turning to CLOs in search of higher yields. These same dynamics have ensured that European issuance reached €14.7 billion in H1 2019, up from €13.3 billion a year prior and a new record.
Momentum in CLO issuance carried over into 2019, in spite of some notable challenges. For one, a regulatory clampdown in Japan, although softer than anticipated, has given investors in the country pause and regulators around the world have expressed concerns over the high volume of market activity. At the same time, uncertainties about how market dynamics will play out, specifically as to CLO arbitrage, suggest issuance could be more conservative this year than in 2018.
Japan’s Final Rule includes welcome carve-out for US CLOs
Japan has become a core CLO buyer. The country's persistent deflationary environment has made investing in domestic fixed income a losing game, and so investors have turned to higher-yielding assets overseas. Japanese banks now account for about 10% of the global CLO market, according to Bank of England estimates.
Concerned by the mass CLO holdings of major lenders, the Japanese Financial Services Agency (JFSA) published proposed risk retention rules for securitized assets in December 2018. The planned rules, which were similar to existing risk retention legislation in the US and Europe, sparked concerns that Japanese investor interest in US CLOs could decline as investing in the asset class would become more costly.
However, when the JFSA published its Final Rule in March 2019, it featured a carve-out for US CLOs. If a US CLO manager has skin in the game (e.g. the CLO is not an “open-market CLO”), the rule should mean Japanese investors need not hold regulatory capital against those assets.
If the US CLO manager has no skin in the game (e.g. the CLO is an “open-market CLO”), however, the JFSA has said Japanese banks cannot rely on open market loan syndication as evidence of the CLO’s risk profile. Instead, the regulator requires that investors perform an “in-depth analysis ... of the quality of the original assets” securitized by the CLO to determine that the underlying loans were not “inadequately formed” (i.e. that they are well underwritten and appropriately serviced).
It remains to be seen how the rules will play out when US CLOs have no skin in the game. This will include most broadly-syndicated loan CLOs, and therefore could potentially have a significant impact. For instance, the JFSA has not said how it views cov-lite loans or what constitutes adequate underwriting or sourcing standards.
Regulators voice their concerns
Japan is not the only one raising the red flag. Globally, regulators have voiced concerns about the leveraged loan market, and CLOs in particular. Yet they have so far taken a wait-and-see approach.
The SEC has eyed developments over the past year, observing a fall in the average rating of the subordinated tranches of CLOs in each of the past two years. This suggests that CLO managers are increasing their risk appetites, either by choice or simply because syndication markets may be offering weaker credits.
In May, the Federal Reserve chimed in, stating: “The historically high levels of business debt and the recent concentration of debt growth among the riskiest firms could pose a risk to those firms and potentially their creditors.” This is significant for the CLO market given that CLOs represent the largest investor base of leveraged loans.
In June 2019, meanwhile, the Financial Stability Board told G20 leaders in a letter that it was “closely monitoring” leveraged loan and CLO markets to obtain a “fuller picture of the pattern of exposures to these assets globally.”
Market dynamics will hold sway
While regulators look on, activity is holding up well. This is despite the fact that CLO arbitrage —the differential between the rates on underlying loans in the CLO and the outgoing returns paid up to investors—has proved challenging in the last year.
Loan rates have come under pressure more recently as market sentiment has changed ahead of the Federal Reserve cutting the base rate, signaling a reversal in its policy. This broadly means marginally weaker loan interest payments on offer to CLOs and their prospective investors.
At the same time, the ample supply of CLOs has meant the spread on AAA tranches has steadily widened since March 2018, squeezing arbitrage, i.e. the differential between the funds coming in from the loan collateral and the outgoing paid on the CLO bonds.
In theory, this should make 2019 a more conservative year for US CLO issuance than 2018. However, CLOs remain attractive to investors compared with other fixed income products, in spite of these arbitrage challenges. As long as equity holders continue to be satisfied and accept the level of return on offer, and Japan's due diligence requirements have limited impact, market forces should sustain another year of strong issuance.