Investment Grade Credit: Securing liquidity
Compliance with the Volcker Rule embedded in the US Dodd Frank Act creates an interesting wrinkle for investors in European collateralised-loan obligations (CLOs). This Rule aims to limit banks’ ‘ownership interest’ in private equity and hedge funds. Together private equity or hedge funds are referred to under the Rule as ‘covered funds’, defined as those which are exempt from registration under the Investment Company Act 1940. As CLOs also rely on this exemption, they could also be caught in this wide definition.
But not all CLOs. Guillaume Jolivet, managing director of structured finance at Scope Ratings, says: “It depends largely on what kind of assets are in the funds and the amount of control or ‘ownership interests’ the banks have over the funds.”
Depending on the structure of the CLO it will either be compliant with Volcker or not – and therefore eligible to be held on a bank’s balance sheet or not. Jolivet says: “This has ramifications for the secondary CLO market because while Volcker-complaint instruments will have good liquidity that will not be the case for those which are not.”
Elissa Johnson, director of loans at Henderson, agrees: “The regulations stipulate that only 3% of a US bank’s risk-weighted assets can be held in covered funds. That’s a tiny proportion of their total capital so it will have an impact on the liquidity of non-Volcker compliant CLOs.”
While it is possible to ensure that new CLO issues comply with the Volcker rule, it is also possible to ‘Volckerise’ existing issues.
In the US market, the loan and CLO market has remained vibrant, with broadly-syndicated loan CLO volumes close to $80bn in 2014 and just above $50bn the year before. That has made it worthwhile to ‘Volckerise’ some transactions from the 2011 and 2012 vintages – principally to ensure these existing issues comply with the ‘ownership interest’ requirements of the Volcker rule. However, this is a complicated process that often requires amending the documentation of the transaction.
In contrast, the European CLO market has been entirely dormant until last year when around €7bn was issued. As result, the stock of ‘2.0 CLOs’ is very low. “The focus in Europe is on ensuring that future deals are compliant with Volcker, rather than trying to ‘Volckerise’ existing deals,” says Jolivet.
The easiest way to ensure compliance with Volcker is for the CLO only to invest in loans. This year there have been a number of European loan-only CLOs. Johnson says: “There have been at least six loan-only deals in the last six months out of a total of 14 deals.”
But the volume of Volcker-compliant loan-only CLOs will always be much smaller in Europe than in the US, simply because there is a very limited supply of loans.
Johnson says: “The US loan market is five times the size of the European market and is very diverse, making it very easy to put together a loan-only CLO.”
In contrast, over the past two years, there has been a rapid increase in high-yield bond financing in Europe, as bank loans have dried up. With limited access to loans, providers of European CLOs may have to look for other ways to comply with the Volcker rule.
There are two options. Johnson says: “Rule 3a-7 says that as long as the CLO only contains floating-rate liabilities, the underlying assets convert into cash at a set maturity date and the investor is not trading the asset for the purpose of making a gain, then it will be Volcker-compliant.”
It is this last condition that is a bit of a grey area. “If a tranche is sold at 101 and another is bought at 99, then the collateral test is enhanced, but while, technically, this not a profit, it could be interpreted as a gain,” explains Johnson.
The other option is to show that the investor does not have beneficial ownership rights. Johnson says: “CLO managers have done this by either arranging for some of the liabilities to have non-voting rights, or for the owner to be able to elect to have non-voting rights.”
However, this way of structuring a CLO to be Volcker-compliant creates liquidity problems, says Johnson. Some new deals are being issued with split-liability tranches – half with voting rights, half without – which reduces the liquidity of each tranche. Others are being issued with electable non-voting rights – and that makes them very difficult to trade.
One investment bank has already said it will not make markets in non-Volcker compliant CLO liabilities, which will further exacerbate illiquidity, Johnson adds.
If getting round the Volcker requirement with either of these strategies either doesn’t work or introduces further complications, then European CLO managers will have to focus on providing loan-only instruments.
Thierry de Vergnes, head of debt investment at Lyxor Asset Management, says: “That is possible but it will take longer because of the lack of depth in the European market. It will take longer to amass all the necessary loans and it will be hard to match the diversity of the US market.”
But it may well be that it’s simply not necessary to provide Volcker-compliant CLOs – at least not over the short-term. “At the moment, traders say there is no premium currently attached to Volcker-compliant European CLOs,” De Vergnes observes. “I would expect it will fluctuate as demand from US investors for European CLOs waxes and wanes.”