CLO market eyeing bonds with a bet on Volcker relief
By Kristen Haunss
NEW YORK, Oct 17 (LPC) - The US Collateralized Loan Obligation (CLO) market is preparing to welcome back high-yield bonds into its funds.
Regulators have signaled they will continue to tweak the 2013 Volcker Rule, a ban on proprietary trading that also prohibits banks from investing in CLOs that hold bonds, after finalizing a round of changes earlier this month.
Anticipating relief for CLOs, THL Credit included so-called ‘Volcker 2.0 Amendment’ language in its THL Credit Wind River 2019-2 CLO, which allows the fund to invest in bonds in the future, according to a deal document. Other managers have recently tried to include provisions for future bond purchases, but the language was scrapped during the marketing process.
The Volcker Rule is part of the Dodd-Frank Act enacted in response to the financial crisis. It forced CLO managers to avoid purchasing bonds so that banks, such as Wells Fargo and JP Morgan, could continue to buy the debt of CLOs.
Rolling back the rule would allow CLOs to purchase bonds, which can have higher yields and could boost returns to the most junior investors, the equity holders, who have seen their income pressured due to wide CLO debt tranche spreads.
Equity holders are paid last with whatever interest is left after all other fund holders are paid. As senior investors take a greater share, distributions to the equity fall. Stronger returns would help boost investment in the riskiest tranche and support continued issuance.
Loans with a B rating had yields of 6.89% in the third quarter compared to 7.27% for high-yield bonds with the same rating, according to Refinitiv LPC data.
“One of the experiences of the crisis, is that markets saw bank loans and bonds don’t work the same way,” said J. Paul Forrester, a partner at law firm Mayer Brown. “A manager would argue that there is opportunity for an arbitrage pickup by trading bonds, and that bonds are easier to get in and out of, so they can be a more efficient use of cash. Managers may also find better value in bonds.”
Some CLOs during the past year have tried to include some form of a springing-bond bucket provision in deal documents, but some investors have pushed back against the option, he said.
Investors may balk at including bonds because they are seeking loan-only products and have allocations to high-yield bonds in other funds.
VOLCKER REVISIONS
The Federal Deposit Insurance Corp (FDIC) in August said agencies intend to put forth additional, specific changes to restrictions on covered fund investments, which could offer CLOs relief.
An FDIC spokesperson did not return a telephone call or email seeking comment.
The loan trade group, the Loan Syndications and Trading Association, sent a letter to regulators last year asking CLOs to be exempt from the covered fund provision.
After the Volcker Rule was finalized, managers began to issue deals that either explicitly banned the ability of the fund to purchase bonds or included a springing-bond bucket, which would allow bonds to be purchased if Volcker went away.
Recently, a number of investors have pushed for an all-out ban on bond language in CLO documents.
The provision in the THL Credit Wind River 2019-2 CLO that priced with Morgan Stanley in September, described as a “Volcker 2.0 Amendment,” has a similar flavor to those 2014 CLOs. The fund has not yet closed.
The CLO will allow issuers to purchase bonds or receive them in an exchange in the future if the Volcker Rule no longer applies, according to Kevin Lycos, a senior analyst at Fitch.
Spokespeople for THL and Morgan Stanley both declined to comment.
As the market awaits regulators’ next move, managers may continue to push for optionality.
“There is always an incentive for managers to have flexibility and equity investors want managers to have that flexibility,” said Kevin Kendra, head of Fitch’s US structured credit group. “The question is whether debt investors are really willing to accept (bond buckets) or will debt investors feel like they are adequately compensated for allowing that additional flexibility.” (Reporting by Kristen Haunss; Editing by Michelle Sierra)
