February 7, 2014 / 4:20 PM / 6 years ago

Volcker Rule scares CLOs out of high-yield FRN market

* Rejigged Loewen Play bond reveals waning CLO bid for FRNs

* Fears the market could wither without their support

* Loewen Play has specific quirks, however

By Robert Smith

LONDON, Feb 7 (IFR) - The growth of the high-yield FRN market could be in jeopardy as new regulatory rules introduced in December begin to impact CLO demand for the format.

The clearest sign of this yet happened this week, when German gaming company Loewen Play was forced to change a new bond offering from floating to fixed rate.

FRNs are attractive to high-yield issuers as they are easier to prepay than fixed-rate bonds, usually with a short one- or two-year non-call period and a lower call premium. Furthermore, unlike most loans, they do not have maintenance covenants, making them valuable in a European market resistant to covenant-lite loans.

“The CLO bid used to be strong for FRNs but has become fairly muted now, as the Volcker Rule is limiting newly formed CLOs’ ability to buy the product,” said Thomas Muoio, European Head of Leveraged Finance Capital Markets at Jefferies.

“I’m not calling the end of the FRN, but let’s see what impact it has, because the European CLOs were always the product’s natural buyers.”

While the high-yield FRN format is virtually non-existent in the US where institutionally sold covenant-lite loans abound, the market grew saw EUR5.5bn of fresh supply last year in Europe, up from EUR3.5bn in 2012, according to Bank of America Merrill Lynch data.


The demand for FRNs has largely come from legacy CLOs about to exit their reinvestment periods. Under pressure to stay invested in floating-rate paper, CLO managers have been happy to turn to the FRN market to source collateral.

This liquidity is now rapidly evaporating. At the start of 2013 there was more than EUR50bn, according to Nomura data, but this dropped to around EUR22bn by year-end, and will have expired completely by the end of 2014.

The hope was that the new wave of CLOs, dubbed CLO 2.0, would fill this void, particularly as many have defined bond buckets. Data from Bank of America Merrill Lynch, however, show that these new CLOs are steering well clear of bonds.

A total of 21 CLOs were priced in 2013 for more than EUR7.5bn. BAML analysed 12 of these, and found that bonds account for only 16% of collateral. And even this overstates the case - Pramerica’s Dryden XXVII and GoldenTree’s GoldenTree Credit Opportunities European CLO 2013-1 drag the average up, with 45% and 40% bonds respectively.

Many in the market point the finger at the US Volcker Rule, which at present prohibits CLO bond-buying. The text so far has a carve out for CLOs backed only by loans, but even European CLOs without bond-heavy portfolios have been unwilling to use it, as managers don’t want to lose this option.


While market participants have blamed the new regulatory rules, Loewen Play’s relative obscurity also did not help, and it remains to be seen if other deals will face the same troubles.

“We had interest from some CLO managers, who might have been looking to put the deal in their other managed funds, but most CLO investors tend to prefer FRNs from issuers they already know in the leveraged loan space,” said Muoio at Jefferies.

FRNs are easier to sell in conjunction with a fixed-rate tranche, as buyers are encouraged to put orders in on both to get a good allocation. But Loewen Play’s deal was too small to tranche in this way.

As well as being relatively unknown, Loewen Play is facing some regulatory headwinds that could impact the credit further down the line.

Germany passed a treaty in July 2012 reducing the number of gaming machines per arcade, effective in all German states. Existing arcade operators, such as Loewen Play, do not have to comply with the new provisions until mid-2017, however.

The legislation’s impact is unclear, particularly as operators are lobbying for a softening of the law. Loewen Play put forth a worst-case scenario, where 60% of its 8,500 machines could be stopped, leading to a 40% drop in Ebitda.

Given this, an investor said it was key to negotiate around the deal’s terms and not simply its price.

“Just increasing the price would only put more strain on the company, while tweaking the covenants gives them less flexibility without damaging them,” he said.

“It’s good that we’ve had a dialogue on this.”

Jefferies was lead-left bookrunner on the B2/B rated deal, which changed from a EUR265m six-year non-call two FRN to a EUR235m seven-year non-call three bond. Credit Suisse was a joint bookrunner. (Reporting by Robert Smith, additional reporting by Owen Sanderson, Editing by Helene Durand, Julian Baker)

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