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CLO problem not solved by Fed’s 2-yr Volcker extension, says LSTA

The Federal Reserve Board announced yesterday that it will give banking entities two additional one-year extensions to conform their ownership interests in and sponsorship of certain CLOs covered by the Volcker rule. The conformance period currently runs through July 2015, and the extensions would give banks until July 21, 2017 to either work with CLO managers to amend non-compliant CLOs, or divest of such investments. The extension applies only to CLOs issued prior to Dec. 31, 2013.

For a copy of the Federal Reserve Board’s statement, click here:

Under the Volcker Rule, CLOs that own bonds and are issued under Rule 3c-7 are ‘covered funds,’ and banks cannot have an ownership interest in a covered fund. Under Volcker, ownership includes ‘the right to participate in the selection or removal of an investment manager’ of the covered fund, outside of an EOD.

The extension is helpful in that it would reduce the impact of Volcker for the vast majority of CLO 1.0s. RBS CLO strategist Ken Kroszner, in a research note issued in response to yesterday’s announcement, says “nearly all legacy CLOs will have amortized by July 2017, so this amendment will likely remove some regulatory risk related to holding these positions for banks. The current 1.0 universe totals $135 billion and we have forecasted a $50 billion run-off in 2014 alone.”

However, the extension does not address the impact of Volcker on CLO 2.0s that will remain outstanding after July 2017. U.S. CLO 2.0s issued during 2014 have generally been structured as Volcker compliant, but the extension would leave uncertainty around the CLO 2.0s issued before 2014 – many of which are likely to be outstanding in July 2017.

“We expect that a vast majority of 2013 vintage CLOs ($80 billion issued in 2013) and most 2012 vintage deals ($55 billion issued in 2012) will still be outstanding at that time given most of these deals were issued with 4-year reinvestment periods. The success of refinancing CLOs with ‘Volcker compliant language’ may help mitigate some of this risk down the road as nearly all of these deals will end their non-call periods before 2016 thereby leaving more than a 1.5 year buffer for most CLOs,” said Kroszner.

As such, although it provides holders of non-compliant CLO debt with additional time to either amend or dispose of this paper, the proposal would fall short of the solution proposed by the Barr Bill, which was approved by the House Financial Services Committee (FSC) last month. That legislation would provide for the grandfathering of all CLO debt issued before Jan. 31, 2014, where the only indication of ownership interest is the ability to participate in ‘for cause’ manager removal.

In response to yesterday’s announcement, the Loan Syndications and Trading Association (LSTA) says the extension will not solve the problem, and that issuing a comprehensive rule that would completely grandfather CLO notes issued prior to the publication of the final rule is needed in order to divert impairment of the CLO market.

“While the LSTA appreciates the Federal Reserve’s efforts to mitigate the damage that the final rule implementing the Volcker Rule would cause to banks holdings of CLO AAA and AA rated notes, a two-year extension of the conformance period does not solve the problem,” said Elliot Ganz, general counsel and executive vice president for the LSTA.

“In its recent cost-benefit analysis, the OCC estimated that the forced divestiture of CLO notes by banks required under the Volcker Rule could cost U.S. banks up to $3.6 billion,” said Meredith Coffey, executive vice president of research & analysis for the LSTA. “In contrast, the expected credit losses on banks’ holdings of CLO notes are less than $2 million. It is ironic that the Volcker Rule, which is designed to limit banks’ investments in risky assets, would force banks to realize billions of dollars of losses in a very safe investment, due to a fire sale.”

Meanwhile, Congressman Scott Garrett, Chairman of the Financial Services Subcommittee on Capital Markets and Government-Sponsored Enterprises, issued a statement yesterday instructing the U.S. financial regulators to go back to the drawing board on their impending “fix,” or risk having it done for them.

“Since the banking regulatory community is unwilling to correct their mistakes, Congress must do it for them. To be frank, this might also have to include Congress looking to make changes to the law such as subjecting these agencies to the appropriations process and further consolidation,” he said. – Sarah Husband

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Volcker Rule’s Non-Exemption Of CLOs With Bonds Holds Potential To Disrupt Market

The reaction to the final version of the Volcker Rule has generally been positive, especially given the obvious attempt by the federal agencies involved to exempt the CLO market from the new regulations. However, there is still concern about possible disruptions to the market in the event that CLO managers are forced to offload securities from their collateral pool, or if banks engage in forced selling of non-exempt transactions.

Elliot Ganz of the LSTA summed up the state of affairs nicely: “While this was a major win, not everything is rosy.”

First, the good news…
Prior to the final rules, there was much concern that CLOs might be categorized as covered funds (hedge funds or private equity funds), as the Volcker Rule prohibits U.S. banks from ‘owning’ covered funds. Banks would have not only been no longer able to invest in CLOs, but also may not have been able to make markets or warehouse CLOs. However, the final rules have gone a long way to exempt loan securitizations (CLOs) under certain conditions – specifically if they do not include bonds or securities.

…And then the not-so-good news
This specific requirement that exempt CLOs must not own securities creates a large issue, however, given the majority of 1.0 and 2.0 CLOs have bond baskets. Furthermore, because there is no “grandfathering” provision in the final rules, any CLOs still owning bonds on July 15, 2015 will not be exempt from the new regulations. As a result, for non-exempt funds CLOs, U.S. banks could not hold an ‘ownership’ interest after July 2015.

A lot remains unclear at this point, including to what extent the Volcker Rule might affect the European CLO market when it comes to U.S. banks investing, warehousing, or trading in European CLOs. Initial reactions from market players here suggest that while Volcker will affect European CLO managers, the impact is likely to be much less severe than for the U.S. market. Nonetheless, any thinning out of the potential triple-A investor base should U.S. banks be unable to invest in the senior debt of non-exempt CLOs is not good news for the development of the market, sources say.

Questions also remain around what constitutes ‘ownership’ of a covered fund, and whether a bank owning debt tranches of a non-exempt CLO equates to ‘ownership’ of a covered fund. The Volcker Rule defines ownership as “any equity, partnership, or other similar interest.” says Wells Fargo CLO analyst David Preston in his Dec. 16 report, CLO Salmagundi: A Deeper Look at the Volcker Rule. Under this definition, owning debt tranches of a non-exempt CLO is not considered ‘ownership’.

However, the “other similar interests” aspect to the definition includes the “right to participate in the removal of… an investment advisor… of the covered fund, (excluding the rights of a creditor to exercise remedies upon the occurence of an event of default or an acceleration event)”, and most CLOs allow triple-A investors certain rights regarding manager replacement, continues Preston.

There is much debate around this particular ownership issue, and in most cases triple-A investors’ ability to remove a manager would fall under the “the rights of a creditor to exercise remedies upon the occurence of an event of default” exclusion, and so would not constitute ownership. However, there is a question about whether the removal rights associated with the ‘for cause’ events often included in the Collateral Manager Agreement fall inside or outside of a perceived event of default, says Preston.

Further debate concerns the key man event and whether or not this could be used as an example of ownership under Volcker.

On a different note, it would appear initial concerns that U.S. banks may be restricted from trading non-exempt CLOs may prove unfounded, as Volcker contains a market-making exemption for banks to act as market makers of covered funds – subject to certain limitations that may impact market liquidity, Preston says.

The consequences
The result could be widespread market disruption, says the LSTA’s Ganz.  Under a scenario where banks could not own CLO tranches, either CLO managers would look to exclude these bonds from portfolios ahead of July 2015, or banks will have to sell out of non-exempt CLOs, putting price pressure on triple-A tranches and leading to potential losses for those banks.

A final course of action, Preston suggests, is to amend CLO documents to list all manager removal clauses specifically as events of default to remove any ambiguity, and to ensure that a close technical reading would not imply that controlling class investors are “owners.”

With regard to the first point, the issue may not ultimately be too big: managers effectively would have until mid-2015 to sell bonds, and 2.0 CLOs generally have smaller bond holdings than 1.0s. In addition, many in the 1.0 group are likely to have amortized or been called by the deadline, according to Preston.

However, while banks, as investors in CLO tranches, will likely push hard for CLO managers to offload their securities and to amend deals to prohibit them from owning securities going forward, some managers simply may not want to sell, or may not be able to sell or amend deals due to resistance from their equity investors.

This could all lead to a differentiation in both value and liquidity between compliant and non-compliant CLOs, as well as the likely emergence of a new CLO 3.0 structure that includes no allowance for bond buckets.

As a result, the LSTA may return to the regulatory agencies to seek relief with respect to the ownership interest. According to Ganz, this would concern “…in particular whether CLOs that have ‘for cause’ manager replacement triggers in triple-A notes are considered ownership interests.” There is also the possibility of asking the agencies to defer the effective date for the divestment of ownership interests.

It may also be possible for triple-A noteholders to contractually give up their replacement rights, thereby negating the indicator of ownership and making it permissible to hold the security, although this option is far from clear, Ganz says.

Ultimately, if there is no regulatory relief forthcoming and existing CLOs do not sell their securities by July 2015, banks would no longer be eligible to hold those triple-A securities.

Further clarity on the rules and their impact should emerge in the coming weeks. Some issues will be thrashed out – if not fully resolved – on the LSTA’s Volcker Rule Webcast, which is being held at 3:00 p.m. EST on Wednesday, Dec. 18. – Sarah Husband

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YouTube, slides: Dec. 2013 European leveraged loan market analysis

LCD’s video analysis detailing the European leveraged finance market during November is now on YouTube.

Loan issuance was €5.4 billion during the month while high yield issuance was €7.4B. Both markets remain buoyant and open. Secondary markets were up, while inflows into high yield funds are estimated to be €1B. The European loan index (ELLI) was up. Four CLOs priced in November, with seven still in the pipeline.

This month LCD looks at:

  • Leveraged loan prices
  • High yield bond prices
  • ELLI multi-currency loan returns
  • Volume: new issue loans vs HY bonds
  • ELLI default rate

The video is available here.

The URL for the video:

PDF slides of the video on Slideshare is available here.

URL for the slides:

While you’re on YouTube please subscribe to LCD’s YouTube Channel. That way you won’t miss any LCD videos. You can also subscribe by clicking on the link to the right of any LCD News email.

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Opal CLO summit: AAAs are key theme amid cautious optimism for 2014

This week’s Opal CLO Summit in Southern California reflected what has been a positive year for the CLO market, although optimism for the year ahead was measured.

More than $76 billion of new CLOs have been issued this year, and next year is expected to get off to a strong start with the pipeline looking full. Managers will look to take advantage of the anticipated renewed demand for the asset class that comes with a new financial year, and both established and new managers will likely look to complete as many deals as possible ahead of the implementation of risk-retention regulation.

There was some discussion of the regulation during the two-day event, but the focus was mostly on arbitrage. Indeed, one of the opening panels of the conference – tackling the triple-A conundrum – established that the recurrent theme of the event would be the outlook for triple-A spreads.

Research analysts speaking at the event had already outlined their predictions for triple-A spreads in their various market outlooks published over the past couple of weeks. All of the panel participants expect triple-A spreads to contract to roughly L+125-135 over the next year, though they believe the tightening will lag other products.

The relative-value play will help bring liability spreads in, as spread-tightening across other ABS products boosts demand for CLO triple-As. Another contributing factor could be the large amount of CLO 1.0 amortization expected next year – in the area of $40-50 billion, some panelists say – which could also increase demand for the triple-As on primary CLO 2.0s as investors look to roll previous commitments into new paper.

However, there are many pieces to the triple-A puzzle and the panel participants took their time exploring various factors.

Demand, for one, is central to the triple-A issue, and with a third of the previous triple-A investor base gone for good as a result of the crisis, the supply/demand equation has gone askew amid this year’s robust CLO volume.

The impact of the FDIC charge also helped curtail regional banks’ appetite during the first quarter, while the Volcker Rule had threatened to remove bank investment in CLOs altogether (although an initial read of the final draft appears to indicate that as long as CLOs do not own bonds, Volcker does not apply).

Given the supply, larger triple-A investors have been able to determine pricing, so that once spreads across the asset class widened this summer, CLO triple-A spreads have remained wide.

There is some tiering evident across managers, and some established managers may have a following of triple-A investors they can take from deal to deal. However, while the reputation and experience of a manager remains important to triple-A investors, there were gripes about the subsequent demand from these investors that managers accept reduced fees.

“If you squeeze managers to the point where they can’t provide proper teams/infrastructure/compliance required to make good investment decisions, then you will be left with the two guys and a Bloomberg model,” said a panelist.

Given the current supply/demand dynamic, some doubt how quickly triple-A spreads will narrow, in spite of the research analysts’ predictions for compression next year.

Even if new investors are slowly showing an interest in the asset class – panelists see increased numbers of triple-A investors versus last year – the time and effort it takes to get those investors approved was described as “gargantuan.”

One panelist suggested that without new investors in the asset class, there may not be meaningful spread compression until risk-retention regulation forces consolidation across the manager space, reducing supply.

Ironically, primary CLO supply could come to a halt anyway, assuming loan asset spreads continue their descent in the absence of any meaningful corresponding compression on the liability side, so that the arbitrage will simply not work.

Better education
One discussion to emerge concerned what is required to bring new investors to the asset class. Certainty around regulation should help when various final rules become effective. But certain panelists said better education about the market and CLO structures is needed to encourage investors who may understand the value in triple-As at current spreads, but who are perhaps nervous about actually investing in the space.

CLOs tend to be viewed as a highly complex investment, and some institutional investors have been reluctant to invest in the structure due to what they believe to be an onerous resource burden required to make an informed investment, according to several panelists. “It’s not a homogenous asset class, and the level of due diligence required is too onerous,” suggested a panelist.

Meanwhile, the perception of CLO space as a tainted asset class in the aftermath of the credit crunch also acts a deterrent. In particular, panelists said this was a factor preventing the participation of potential investors such as corporate treasurers with huge cash amounts. “Are CLOs attractive to the cash/short duration investor?” asked one panelist. “Yes, from a credit-risk perspective, but the legacy of the crisis is so severe that the perceived toxicity of the product is still a huge hurdle.”

The argument went so far as to say that while 145 bps looks attractive from a relative-value perspective, it perhaps isn’t so appealing to a corporate treasurer who is unwilling to risk career suicide on a CLO investment.

The takeaway was that better investor education could help improve the general understanding and perception of CLOs, and in time could help deepen the investor base. As part of that education process, panelists suggested that software and data tools to help evaluate and understand structures would be helpful, while noting that standardization of CLO documentation might also prove beneficial.

To this point others argued that over-standardization that removed flexibility for a particular CLO manager could also act as a disincentive to established managers going forward. “As soon as you standardize, you don’t get any benefits as a manager above first-time issuers,” said one CLO manager. – Sarah Husband

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YouTube, slides: December 2013 US Leveraged Loan Market Analysis

LCD’s video analysis detailing the US leveraged finance market during November is now on YouTube.

New-issue leveraged loan activity pushed further into record territory during the month. The S&P/LSTA Index posted a 0.49%. The universe of S&P/LSTA Index loans grew by $22 billion, to a record $674 billion. Inflows accelerated. The loan default rate eased.

Looking ahead, the calendar of new M&A-driven transactions remains light.

This month LCD looks at:

  • Leveraged loan volume; M&A loan volume
  • Average Bid of S&P/LSTA Loan Index
  • S&P/LSTA Index Loans Outstanding
  • Visible Inflows
  • Average New-Issue Clearing Yield of First Lien Loans
  • Loan Default Rate
  • M&A Institutional Loan Forward Calendar


The video is available here.

 

PDF slides of the video on Slideshare.

 

While you’re on YouTube please subscribe to LCD’s YouTube Channel. That way you won’t miss any LCD videos. You can also subscribe by clicking on the link to the right of any LCD News email, or here:

http://www.youtube.com/user/LCDcomps

If you’d like to embed an LCD video on a web page or in other digital media, it’s simple via the “embed” button on the YouTube page for the video. You can also embed the slides via Slideshare.

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S&P report: Midsize UK firms seek new funding sources

imagesMore information about the financial performance of U.K. midsize companies could help in the development of capital market funding for this sector, says Standard & Poor’s Ratings Services in a new report titled “Midsize U.K. Companies Seek New Funding Sources To Unlock Growth.

As the U.K. economy starts to recover, U.K. mid-market companies – which S&P defines as firms with revenue of between €100 million and €1.5 billion (between £85 million and £1.3 billion) – face a contraction in bank lending, potentially limiting their opportunity to grow and develop. While alternative sources of funding are available, potential investors are, in the agency’s view, being held back by a lack of transparency on mid-market companies.

S&P has analyzed an overall dataset of non-financial parent companies operating in the U.K., for which it found more than 30,000 listed and unlisted companies tracked by S&P Capital IQ.

“The results from this group show that, for the past seven years, profit margins are on average 1.7 times lower for U.K. mid-market companies compared with their larger peers, although they are less volatile,” said Standard & Poor’s research analyst Taron Wade. “Our study also found that U.K. midsize companies consistently maintain higher cash and short-term investments to total assets than their large and small peers, and maintain more conservative financial leverage ratios than large U.K. companies.”

In general, the sector-by-sector breakdown of U.K. mid-market companies mirrors the larger market, with the majority of firms operating in the consumer discretionary (ie., non-essential goods and services such as retail, media, and autos) and broad industrial sectors. Exposure to these sectors should help U.K. mid-market firms to benefit from the economic turnaround.

According to S&P’s economic research, the largest contribution to GDP growth on the output side of the economy in the third quarter of this year came from the services sector, which increased by 0.7% quarter-on-quarter. Consumer spending is likely to contribute the most to economic growth in the coming two years, and the agency estimates private demand will rise by 2.3% in 2014 and 2015, supported by improved confidence, rising employment, and an improving housing market – all of which should boost consumption and reduce the savings rate.

Mid-market companies in the U.K. are ten times greater in number than their larger peers in the country, and generated roughly a quarter of total sales for U.K. firms in 2012. However, while mid-market companies contribute a great deal to the local economy, they are more sensitive to the contraction of bank lending than their larger peers. And even though the U.K. private placement market is growing – with an estimated £6 billion raised in the past three years – in S&P’s view it lacks transparency in terms of transaction flow, and there are barriers to further development, including regulation. – Staff reports

The report is available to subscribers of RatingsDirect at www.globalcreditportal.com and at www.spcapitaliq.com. If you are not a RatingsDirect subscriber, you may purchase a copy of the report by calling (1) 212-438-7280 or sending an e-mail to research_request@standardandpoors.com.

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European borrowers raise record US loan volume, despite more new issuance in Europe

European borrowers have raised record loan volume in the U.S. this year, even though more buoyant new issuance at home is helping to reduce the relative importance of the Yankee market.

LCD data show that, in the year to Nov. 20, Europeans borrowed some €27.8 billion from the U.S. loan market, which is the highest on LCD records dating back to 2005, and significantly up on the €21.7 billion tracked last year.

For Europeans, the attractions of the U.S. are clear given the market’s ability to deliver big-ticket funding at a price and terms that lenders here have struggled to match. The sheer depth of this liquidity has also opened the way for a return of pre-crash features such as covenant-lite loans, with European borrowers sometimes using the weight of U.S. demand to harry less-than-enthusiastic investors on this side of the Atlantic into new structures. The U.S. has also been receptive to borrowers without a natural dollar revenue source, allowing credits such as German foam-maker Armacell to complete cross-border financing despite having no significant U.S. operations.

In these circumstances, the U.S. has helped as a catalyst for renewed European new-issue loan activity and today’s leveraged loan market looks increasingly global in outlook. In this respect the dual-tranche European and U.S. loan is now commonplace, with borrowers weighting the dollar and euro split according to demand.

But the renewed health of markets here also means U.S. loans from European borrowers as a proportion of overall European borrowing activity is declining. LCD data show U.S.-syndicated loans represent a 33.5% share of all loans signed by European borrowers this year, which is a good deal lower than the 44.7% recorded last year when domestic issuance was rather more sickly. In the year to the end of October, European-only issuance had already exceeded all full-year figures since 2007, at €57.4 billion (more than double the €24.2 billion seen at the same time last year). Sponsored issuance, meanwhile, accounted for €38.7 billion between January and October, up 87% year on year, and a five-year high.

A renewed attention on loans from investors alongside a partial lifting of the continent’s economic gloom has helped drive demand and boost the appeal of the home market. Just this week, for example, CPA recut its cross-border $1 billion recapitalisation to adjust the facility towards the euro tranche and introduce a rare euro-denominated second lien piece. Also this week, British software group Misys carved out €50 million from its previously all-dollar $200 million term loan add-on.

Pricing is still more attractive in the U.S., however, with both Misys and CPA Global paying the customary 25 bps premium on their euro tranches, even after some tightening. Moreover, covenant-lite is still only available on a cross-border basis and the format has not been seen on a purely European syndication since the financial crisis. But with investors seemingly open to the structure on a cross-border and FRN basis, most bankers predict it won’t be long before such deals make a full return here. –David Cox

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YouTube, slides: Nov. 2013 European leveraged loan market analysis

LCD’s video analysis detailing the European leveraged finance market during October is now on YouTube.

The European leveraged finance primary and secondary markets had a moderate month. Loan issuance was €2.3 billion in October 2013, while high yield issuance was €5.3 billion.

Estimated inflows to European high yield funds for October are a gigantic €1.32 billion, bringing the estimated year to date number to €4.87 billion. A slew of CLOs are expected to price before the end of the year.

This month LCD looks at:

  • Leveraged loan prices
  • High yield bond prices
  • ELLI multi-currency loan returns
  • Volume: new issue loans vs HY bonds
  • Volume: PIK toggle notes
  • ELLI default rate


The video is available here.

 

PDF slides of the video on Slideshare is available here.

 

While you’re on YouTube please subscribe to LCD’s YouTube Channel. That way you won’t miss any LCD videos. You can also subscribe by clicking on the link to the right of any LCD News email.

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YouTube, slides: November 2013 US Leveraged Loan Market Analysis

LCD’s video analysis detailing the US leveraged finance market during October is now on YouTube.

In early November, new-issue activity surpassed the prior high of $535 billion from 2007. While the headline figure is in record territory, 2013 deal mix is more heavily opportunistic, with far fewer mega-LBO deals to drive acquisition-related activity.

This month LCD looks at:

  • Leveraged loan volume
  • Average Bid of S&P/LSTA Loan 100 Index
  • S&P/LSTA Index Loans Outstanding
  • Visible Inflows
  • Average New-Issue Clearing Yield of First Lien Loans
  • Loan Default Rate
  • M&A Institutional Loan Forward Calendar


The video is available here.

PDF slides of the video on Slideshare.


While you’re on YouTube please subscribe to LCD’s YouTube Channel. That way you won’t miss any LCD videos. You can also subscribe by clicking on the link to the right of any LCD News email, or here:

http://www.youtube.com/user/LCDcomps

If you’d like to embed an LCD video on a web page or in other digital media, it’s simple via the “embed” button on the YouTube page for the video. You can also embed the slides via Slideshare.

 

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US leveraged loans return 0.73% in October; YTD return is 4.28%

The temporary truce Washington’s fiscal standoff set off a rally across the capital markets that helped lift S&P/LSTA Loan Index returns to a three-month high of 0.73% in October, from 0.24% in September. The largest loans that comprise the S&P/LSTA Loan 100 Index outperformed with a 0.86% return after lagging in September at 0.14%.

In the year to date, the S&P/LSTA Index has returned 4.28%, versus 8.46% during the same period in 2012. The Loan 100 Index, meanwhile, has returned 4.01%, versus 9.24% during the first 10 months of 2012.