Asian Invasion into US Collateral Loan Obligations

Collateral loan obligations (CLOs) are a form of securitisation where leveraged loans from multiple corporate loans are pooled together in a special purpose vehicle (SPV). Leveraged loans are those loans extended to companies that already have considerable amounts of debt – as these loans are at higher risk of default, they cost the borrower more in interest. The SPV then issues bonds that are sold to investors in several different tranches with varying levels of rights to collateral and the payment stream. There are typically AAA rated (generally 64% of the total investment), AA, BBB, mezzanine, and equity (10% of total investment) tranches. CLOs are popular as arbitrage conduits that generate equity returns through leverage by issuing debt that is around 10 times their equity contribution. An alternative type is the market-value CLOs that are less leveraged, around 4 or 5 times, but that allow managers greater flexibility than the more tightly structured arbitrage CLOs. CLOs are typically rated by the major ratings agencies – Moody’s, S&P, Fitch. CLOs also enforce several covenant tests on the collateral managers covering areas such as minimum rating, industry diversification, and maximum default basket. The attraction of CLOs is that it makes it easier for companies to borrow by allowing banks to transfer loans they originate, as well as the risks attached to the loans, to institutional investors.

In 2006 and 2007, CLO volumes were roughly US$190 billion. CLO volumes dipped to negligible amounts in 2009 and 2010, before a resurgence in 2011 and 2012 during which US$70 billion of CLOs were recorded. In the current low-yield environment, the CLO market is making a comeback. The yield in a CLO rated BBB or in the equity tranches is much higher than in similar rated fixed income instruments. In particular, Asian investors, who have felt less of a sting from the financial crisis and who are cash-rich, are driving demand for CLOs as they seek higher yield. The keenest investors seem to be North Asian insurers struggling with high guarantees on their historic business, such as Sompo Japan Insurance, Tokio Marine, and KB Life Insurance. Already in 2013, we have seen 18 deals of around US$9 billion in January and US$6.5 billion of issuance in February. The market is expected to reach US$75 billion by year end. The typical client in the CLO market is also diversifying away from merely US investors with North Asian investors seeking more sophisticated asset classes. It is an important trend to take advantage of the US market for leveraged loans - worth around US$1 trillion – especially as in 2012 50% of new leveraged loans originated by banks were purchased by CLOs.

CLOs are safer than other forms of securitisation that had infamous roles in the subprime mortgage crisis and subsequent credit crunch. CLOs are a first derivative securitisation as the underlying assets are leveraged loans. However, CDOs are a second derivative securitisation as the underlying assets are other securitisations such as mortgage-backed securities, SME-backed loan securities, and CDOs. Therefore it is easier to evaluate a CLO portfolio than a CDO portfolio. In addition, trustees typically report every month to investors on the collateral, underlying credits, payment waterfall and the net asset value (NAV). Additionally, out of 41,120 tranches of CLOs rated by Moody’s from 1996 to 2012, only 32 tranches or 0.8% hit event of default and suffered losses on the principal investment at maturity. Therefore, CLOs had a low default rate before and during the financial crisis. 2013’s bullish prospects for US corporate credit, transparency in the underlying assets, good track record, and the added yield offered by CLOs are all factors that make purchasing CLOs attractive this year.

However there is one caveat. Regulation has impacted the CLOs market, which has ensured that the US market will see stronger growth than in Europe. Article 122a of the EU Capital Requirements Directive and the Dodd-Frank Act have both incorporated the concept of risk retention which require the CLO manager to retain at least 5% of the total size of the CLO until maturity. The rule in the Dodd-Frank Act does not come into effect in the USA until 2015, but there are attempts to exempt CLOs from the risk retention rule. Conversely European CLO is low as European banks have been unwilling to comply with the risk retention requirement due to low leveraged loan issuances in Europe as well as potentially high liability spreads across the different tranches of a CLO. Therefore, it is likely that demand will dampen for US CLOs if they are not made exempt from the risk retention rule.