Non-Volcker compliant AAA CLO paper has widened in the secondary market over the past couple of months ahead of a key deadline arriving tomorrow that prohibits U.S. broker-dealers from making markets in non-compliant paper.
Morgan Stanley CLO research analysts, Richard Hill and Mia Qian, in their June CLO Market Tracker research report, estimate that the basis to Volcker compliant CLOs is now more than 50 bps, which in their view, is due to diminished liquidity in this paper.
For those of you not yet fed up with hearing about Volcker and its impact on the CLO market, here is a run through the key points:
The Volcker Rule effectively prohibits U.S. banks from holding ownership interests in “covered funds,” and a CLO that includes bonds in its collateral pool, and which is issued under Rule 3c-7, is classed as 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 event of default.
To be clear, tomorrow’s deadline only restricts U.S. broker-dealers from making markets in non-compliant CLO paper. Via an extension granted by the Federal Reserve last December, banks are still able to hold non-compliant CLO paper on their books through July 21, 2016 (with an additional extension through July 21, 2017 expected). However, this extension applies only to non-compliant paper held by banks as of Dec. 31, 2013, and thus, as of tomorrow, banks are no longer expected to trade or make markets in non-compliant paper, which has constrained liquidity in recent months.
There is a market-making exception that allows bank trading desks to trade non-compliant CLOs, but the exception contains two large impediments which could limit its use, according to Wells Fargo. “First, the bank faces a firm-wide limit for Volcker exceptions of 3% of Tier 1 capital; the bank then must decide how much of that exception to allocate to the trading desk. Second, any non-Volcker compliant tranches incur dollar-for-dollar capital charges against the banks’ Tier 1 capital,” the firm noted.
In terms of market impact, Wells Fargo analyst David Preston summarized in his February 2015 CLO Desktop Regulatory Guide research report that the majority of all CLO 1.0 deals should be paid off by 2017, that most post-2014 CLOs are Volcker compliant (i.e. do not include bond buckets), and so it’s the 2012 and 2013 vintage CLOs that are the issue, of which there was roughly $130 billion outstanding as of February this year.
Since the final version of the Volcker Rule was released in December 2013, CLO managers and their investors have been busy amending existing transactions to remove bonds. Some have done this via painstaking amendment processes with their investors, while others have used the CLO refinancing route to remove bonds, with 14 of the 22 refinancing transactions pricing so far in 2015 removing bonds via the process, according to LCD.
Although most players do not expect any further regulatory relief – there is the wild card of the “Barr bill” is still outstanding. Congressman Andy Barr has sponsored two Volcker-related bills – H.R. 37, or the ‘Volcker bill,’ which passed to the Senate earlier this year, and which includes a provision that would allow banks until July 21, 2019, to divest non-compliant CLO holdings – and H.R.1841. This latter bill was introduced in March and, while reintroducing the Volcker extension, also seeks to amend Section 13 of the Bank Holding Company Act of 1956, known as the Volcker Rule, to allow CLOs to have ownership interests in a hedge fund or private equity fund.
Still, one man’s loss is another’s gain and for investors that are not particularly concerned about liquidity, Morgan Stanley’s Hill and Qian think non-Volcker compliant legacy CLO AAA paper presents an attractive investment opportunity, given the much wider spread levels and relatively short weighted average life. – Sarah Husband
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