Loan market asks regulators to allow CLOs to hold bonds

NEW YORK, Oct 18 (LPC) - The US$1.1trn US leveraged loan market has asked regulators to exempt Collateralized Loan Obligation (CLO) funds from a provision in the Volcker Rule to allow them to buy bonds to boost their income.

The Loan Syndications and Trading Association (LSTA) sent a letter this week to regulators including the Federal Reserve (Fed) and the Office of the Comptroller of the Currency (OCC) asking that CLOs be exempt from a covered fund provision in the Volcker Rule, which stopped banks from investing in CLOs that own bonds.

Volcker was aimed at eliminating proprietary trading and is part of the wider Dodd-Frank Act. It forced CLO managers to avoid purchasing bonds so that banks, such as Wells Fargo and JP Morgan, could continue to buy CLO debt.

Rolling back the rule would allow CLOs to include bond buckets. This could boost returns to the most junior investors, the equity holders, who have seen their income hit by record loan refinancings and increasing tranche spreads.

Equity holders are paid last with whatever interest is left after all other fund holders are paid. As less interest is paid to the fund and senior investors take a greater share, distributions fall. Stronger returns would help boost investment in the riskiest tranche of CLO funds and support continued issuance.

“If agencies either treat CLOs with bond baskets as loan securitizations or recognize that the right to remove the manager is not an ownership interest, it would allow CLO managers to hold a limited number of bonds in their portfolios, which would give them some additional flexibility in appropriate markets,” Elliot Ganz, general counsel at LSTA, said in an interview.

The LSTA submitted its letter in response to regulators’ request for comment in May.

A reprieve from the Volcker Rule would be another win for the US$567bn US CLO market after the US Court of Appeals for the District of Columbia Circuit earlier this year ruled the funds were exempt from risk-retention regulations that require managers to hold some of their deal.

CLOs are the largest buyers of US leveraged loans, which companies including American Airlines and retailer Party City use to fund their operations. A healthy market can support more loan issuance, which also boosts mergers and acquisition activity, and allows companies to cut borrowing costs.

There has been US$104.1bn of US CLOs arranged this year through October 12, which ranks 2018 as the third-largest year ever, behind a record US$123.6bn in 2014, according to LPC Collateral data. Wells Fargo is predicting a new record of US$150bn of issuance in 2018.


The LSTA, the trade organization for the US loan and CLO markets, said in its October 16 letter that it fully endorses a revision of the definitions of “loan securitizations” and “ownership interest” in a way that does not hinder the CLO market.

“We urge the agencies to permit CLOs and other loan securitizations to hold up to 10% of their holdings in non-loan assets, including corporate bonds, interests in letters of credit, cash and short-term highly liquid investments and derivatives,” the LSTA said.

It specifically called for modifying the loan securitization section so that it “clearly and effectively” excludes traditional CLOs from the definition of the term “covered fund.” This would allow banks to purchase CLOs with non-loan asset holdings, including bonds.

The organization is also asking agencies to reconsider the term “ownership interest,” noting that the right to remove and replace a manager is a central characteristic of a creditor in a debt security, not equity as understood in the original rule, according to Ganz. Banks can hold debt securities of covered funds, but not equity.

The Investment Adviser Association (IAA) also sent a letter to the agencies this week, saying that it agrees with the LSTA’s initiative to allow CLOs to hold up to 10% of high-yield bonds.

“This modest percentage of non-loan assets would allow loan securitizations to increase diversification and enable their asset managers to be responsive to changing market conditions,” the IAA said.

Spokespeople for the Fed, OCC and Securities and Exchange Commission declined to comment. Spokesperson for the Federal Deposit Insurance Corp and Commodity Futures Trading Commission were not immediately available to comment. (Reporting by Kristen Haunss Editing by Tessa Walsh and Jon Methven)