NEW YORK (Reuters) - An initial reading of the Volcker Rules has generally left those active in the collateralize loan obligation (CLO) market breathing a sigh of relief. The final draft of the new banking legislation largely preserves CLO structures and origination mechanisms but may spur banks to divest some CLO debt and equity holdings and CLO managers to dump high-yield bonds.
Prior drafts of the legislation carved out CLOs from the definition of loan securitizations, a move that could have barred banks from making markets in CLO debt and establishing warehouse funding for CLO managers building portfolios before pricing a deal. Loan securitizations are exempt from the Volcker Rule.
“The final Volcker legislation broadens loan securitizations to cover CLOs and provides a path for CLOs to exempt themselves from the definition of ‘covered fund,’” said Elliot Ganz, general counsel at the Loan Syndications and Trading Association. “These developments should preserve most of the current features and functions seen in today’s CLO market.”
To avoid falling under the definition of a covered fund, which are subject to stricter regulatory oversight, CLOs can only hold loans, cash equivalents and foreign exchange and interest rates hedges, but no securities or commodity forwards.
While banks can make markets in covered funds, subject to a litany of market-making restrictions, banks cannot generally own an equity interest in covered funds. The intent behind the rule is to prevent banks from engaging in proprietary trading, but not acting as a trading liquidity agent or underwriter of covered funds.
Unless CLO managers cleanse portfolios to avoid becoming covered funds, U.S. banks holding senior CLO debt or equity tranches in their non-market making portfolios could become forced sellers of these relatively illiquid securities.
Senior Triple A CLO debt tranches may be caught under Volcker ownership definitions that include the right to replace investment managers and general partners - making it impossible for banks to hold such paper. The indentures of many Triple A CLO debt tranches empower bondholders to remove existing managers.
“On the face of the rule text, it appears that the traditional ability of Triple A CLO note holders to remove managers for cause would cause a non-excluded CLO to fall under Volcker’s covered fund ownership prohibition,” said J Paul Forrester, a partner at Mayer Brown’s structured finance practice. “If, as is likely, this is an unintended result, interpretative relief would likely be needed to clarify this important issue.”
If the ownership provisions do ensnare the Triple A liabilities of covered funds, forced sales are likely. U.S. banks have traditionally been the biggest purchasers of Triple A CLO liabilities, which are typically the largest and most difficult tranches to place.
The outlawing of banks holding CLOs containing securities is likely to mean that managers sell high-yield bonds or chunks of other CLOs to remove them from the structures.
“CLOs that own securities, which include high-yield bonds and CLO tranches, may be under pressure to sell such holdings to facilitate continued relationships with bank investors,” said Daniel Hartnett, a finance partner at Kaye Scholer.
Bond holdings represent only about 2.6 percent of all assets in CLO portfolios, according to Thomson Reuters data. This translates into $7.2 billion of bonds spread across more than 700 CLOs.
However, the difference in yields paid by leveraged loans and high-yield bonds, which is amplified by embedded CLO leverage, could reduce CLO equity returns if bonds are sold. The average yield-to-worst of a high-yield bond is currently 5.67 percent, according to the Bank of America Merrill Lynch High Yield Index, whereas Thomson Reuters data calculates current primary leveraged loan yields at 4.86 percent.
In addition, a number of CLOs contain tranches with fixed coupons. Removing fixed coupon bonds that earn a spread over such tranches also could affect returns.
Affected CLO managers would need to consider shedding their bonds soon, since the Volcker Rules, which become partially effective at the beginning of April 2014, do not allow for any “grandfathering” or holdings exemptions for existing CLOs. Banks have until July 21, 2015, to fully conform to the new rules.
“Although the Volcker Rule could arguably reduce CLO equity returns by effectively eliminating the bond bucket for CLOs looking to meet the loan securitization exemption, the final Volcker Rule does validate the role of CLOs in enabling banks to continue creating and extending credit,” said Deborah Festa, a partner in the Alternative Investments practice at Milbank Tweed Hadley & McCoy.
Editing By Jon Methven