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Revived Japanese bank demand should tighten CLO ‘AAA’
admin | March 29, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Spreads on ‘AAA’ classes of CLOs have lagged the tightening in competing parts of US fixed income so far this year. Highly rated corporate debt and CMBS have both outrun the top of the CLO capital structure. Part of the weakness likely reflects a December 28 proposal by the Japanese Financial Services Agency to require heavier capital charges on CLOs that lacked risk-retention. But a final rule published March 15 imposes lighter conditions. The Japanese bank bid for ‘AAA’ looks likely to get some new life, and CLOs should close some of the spread gap to competition.
CLO ‘AAA’s have lagged CMBS and investment grade corporates
Benchmark CLO ‘AAA’ spreads have tightened only 6 bp so far this year while CMBS ‘AAA’s have tightened 17 bp and investment grade corporates 26 bp (Exhibit 1). That leaves CLO ‘AAA’ spreads to CMBS ‘AAA’ at the widest level in at least a year, and spreads to investment grade corporates near their widest level in at least a year.
Exhibit 1: CLO ‘AAA’ have lagged other sectors … Spreads to CMBS, IG are at or near 1-year wides
Source: CLO AAA from the Palmer Square CLO Senior Index, CMBS AAA Commercial Real Estate Direct, IG Cash Spread from Bloomberg via Bloomberg; Amherst Pierpont Securities
A range of factors shape spread differences across sectors over time including shifting credit fundamentals and supply and demand, but only two have shifted materially since the start of the year: the outlook for Japanese demand and arguably the interest in floating-rate product.
Risk to Japanese bank demand recently resolved
The JFSA proposed in December that banks and other regulated institutions investing in structured products hold three times more capital for structures lacking risk-retention than for structures including it. Since a February 2018 ruling in the US Court of Appeals for the DC Circuit exempted US CLOs from risk-retention, the JFSA proposal could have put a punitive capital burden on the sector. Japanese banks hold an estimated 10% of global CLO debt, according to a November 2018 estimate by the Bank of England, so weaker demand from Japan would have softened US CLO investment grade spreads (Exhibit 2).
Exhibit 2: Japanese banks are the fourth largest investor in global CLOs
Source: Bank of England Financial Stability Report, November 2018, Chart F.8, Amherst Pierpont Securities
The recent JFSA final rule, according to analysis by Dechert, allows a regulated Japanese investor to avoid a 1.25% risk weighting for each CLO class by ensuring that assets backing a CLO “were not inappropriately formed.” For a US CLO, this generally involves determining whether underlying loans were well underwritten and will be adequately serviced. “We expect that this will lead to increased due diligence by Japanese investors not only with respect to the loans in the CLO at the time the Japanese investors acquire their CLO notes,” Dechert writes, “but also with respect to the credit underwriting and servicing practices of the collateral manager and the stress testing and structuring of the CLO.”
The FSA rule seems likely to increase Japanese investors’ preference for CLO managers that can facilitate the required due diligence, but the rule should leave most other current standards and practices intact. Spreads on these CLO managers’ deals seem likely to tighten first, with spreads on other managers’ deals following.
A weak case for shifting rate preferences
A shift in investor preferences away from floating-rate products seems less clear a factor in poor CLO ‘AAA’ performance. The Fed has become much more dovish this year, and some investors might have shifted away from floating-rate products to add more duration. But most CLO investors are institutional portfolios able to manage duration in other ways such as extending duration in other asset classes or swapping their CLO exposure from floating-rate to fixed. In fact, wide CLO ‘AAA’ spreads and the currently inverted yield curve would argue even more strongly for holding floating-rate positions and extending duration in other assets.
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