CLOs warn investors Japanese retention proposal could affect liquidity

NEW YORK, Feb 1 (LPC) - Collateralized Loan Obligation (CLO) managers are warning investors that a new Japanese regulatory proposal may limit their ability to sell their debt holdings at a later date.

PGIM and Octagon Credit Investors are among investment firms that listed the new retention proposal as a risk factor in CLO documents last month, according to sources. Both managers said they would not comply with the requirement, which is not yet final and is not expected to take effect before March 31, but warned the rule may make it more difficult to resell the debt starting in April.

The Japanese Financial Services Agency (JFSA) in December 2018 published a proposal that would require Japanese investors to apply a higher risk weighting to securitizations they hold unless the fund “originator” holds a portion of the fund. If the CLO does not meet that standard, the investment will be assigned a triple risk weighting in the calculation of the Japanese financial institution’s capital adequacy ratio.

The regulator previously told LPC that it does not anticipate providing any unconditional exemption for specific products, such as CLOs, but that it will not apply the weighting if it can conclude the origination of the underlying assets are arranged “appropriately.”

“If it is determined that the Japanese retention requirements apply to CLO transactions, such requirements might apply in respect of a refinancing or additional issuance and may limit liquidity and trading of the (fund’s) notes,” PGIM wrote in the deal document for its Dryden 71 CLO.

CLOs are the biggest buyers in the US$1trn US leveraged loan market, which highly indebted companies including American Airlines and retailer Party City rely on for financing. Japanese banks account for about 10% of the US$750bn global CLO market, according to a Bank of England estimate, and a pullback by these investors could make the funds more expensive, decreasing new issuance, and in turn raising borrowing costs for US companies.

US loan trade group the Loan Syndications and Trading Association sent a letter to the JFSA on January 28 arguing the loans the funds buy are analyzed by multiple parties during the syndication process and as such are not “inappropriately formed,” meeting the regulators’ specification for originated assets that could exempt the funds from the rule.

A US Appeals Court last year exempted CLOs from a similar US rule stemming from the massive Dodd-Frank regulation created after the credit crisis. European risk-retention rules are still in place.

If not excluded, CLO managers may be forced to hold a portion of their fund in order for Japanese institutions to participate in their deal. Funds issued before the effective date will be “grandfathered in” and not require retention, however if the CLO is reworked in the future, retention may be needed.

A PGIM spokesperson and an Octagon representative both declined to comment.


Japanese investors have been involved in the US CLO market for a long time, often buying an entire Triple A tranche, so they can set market terms, according to Collin Chan, a CLO strategist at Bank of America Merrill Lynch. The Triple A slice is the largest and most senior portion of the CLO.

A potential pullback by this investor base raises concerns that tranche spreads could move higher, as investors stepping in to fill the void demand more compensation. That would leave less interest to pay holders of the most junior portion of the funds, the equity, who receive whatever is left after all debt holders are paid. If equity distributions decrease, the economics of raising a new fund would be increasingly difficult.

Triple A spreads were already widening among record issuance, jumping from the low 90bp range for a handful of CLOs in March through May of last year to a December coupon high of 133bp, according to LPC Collateral data. Citigroup is predicting spreads could move to the 140bp-145bp range by the end of the year.

“The fact they are so big and can put that much (money) to work, without their bid, the CLO market would see meaningful lower volume,” Chan said, referring to Japanese investors. (Reporting by Kristen Haunss Editing by Lynn Adler and Kristen Haunss)