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The exchange rate drag on Japanese demand for US CLOs and other debt

| May 3, 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 US CLOs have lagged behind the tightening in other parts of fixed income this year, and part of the reason may be the high cost of hedging currency risk for Japanese investors. Japanese portfolios hold an estimated 10% of outstanding global CLO debt, and hedging now adds significant cost to dollar exposures while actually helping euro exposures. That’s not the only thing temporarily weighing on CLO spreads, but it’s an important one.

CLO spreads lag the tightening

Since the beginning of the year, benchmark CLO ‘AAA’ spreads have tightened 8 bp with other parts of US fixed income much tighter. Spreads on 3- to 5-year investment grade corporate debt, for instance, have tightened 48 bp, and spreads on CMBS ‘AAA’ have tightened 26 bp (Exhibit 1).

Exhibit 1: CLO ‘AAA’ spreads have lagged other sectors

Source: Bloomberg, Amherst Pierpont Securities

The poor showing by CLOs likely reflects a number of things. Many of the issuers building portfolios in warehouse facilities last fall found themselves at the end of the year with loans trading well below par, and any tightening in loans this year has promised to quickly bring new CLO supply. Banks providing funding to these warehouses have also found themselves near capacity and have started to pressure their CLO clients to issue. There may be some concern about recession and the recovery rates on leveraged loans after years of loosening underwriting, but spreads in high yield debt have tightened despite related concerns. Then there is potential demand from Japan.

The yen carry trade

Low yields in Japan for years have driven the yen carry trade where investors inside and outside Japan borrow capital in yen at exceptionally low and at times negative interest rates, exchange the capital into another currency and invest it at higher yields. The capital and profits or losses on the investment eventually need to be converted back into yen, which introduces currency risk. Any appreciation in the currency where the capital is invested relative to the yen will increase the returns to the investor while any depreciation in the investment currency will decrease returns. For now, the forward market for current implies that the euro will appreciate against the yen while the dollar will depreciate.

Investing JPY in USD CLOs vs EUR CLOs

Money market rates in Japan are currently negative, meaning investors can borrow 100 million yen, for example, and repay 99.975 million yen three months from now (Exhibit 2). The 25,000 yen difference is a gain on the loan that will be added to the projected profits from the investment.

Exhibit 2: Cost of capital in Japan

Source: Bloomberg, Amherst Pierpont Securities

Japanese banks and insurance companies are active investors in the AAA-rated tranche of CLOs in the US and in Europe. The underlying floating rate index for USD CLOs is typically 3-month LIBOR, and in EUR it is 3-month EURIBOR (Exhibit 3). Three-month EURIBOR is currently negative, but, like many floating rate securities, CLOs include a floor of zero for the index. That leaves the coupon on a euro CLO effectively floored at the spread, which in this case is 108.5 bp.

Exhibit 3: Coupon comparison of recent USD and EUR issued CLOs

Source: Bloomberg, Amherst Pierpont Securities

The USD CLO coupon is currently 282 bp higher than the coupon of the EUR CLO, which certainly provides significant a carry advantage at least for the first floating rate period. However, when the spot and forward exchange rates are incorporated, the EUR CLO is projected to outperform the USD CLO over both 3-month and 1-year holding periods (Exhibit 4).

Exhibit 4: Comparison of EUR and USD CLO cross-currency carry trades from JPY

Source: Bloomberg, Amherst Pierpont Securities

What happened to the 2.82% of additional coupon of the USD CLO versus the EUR CLO? It was eroded away by the 2.85% projected depreciation of the US dollar versus the yen over the next year, versus a 0.09% projected appreciation of the EUR versus the yen over the same period.

Floating rates in the US are projected to decline

The differences in projected returns are somewhat modest—8 bp over three months, 21 bp over one year—but this doesn’t tell the whole story. Floating rates in the US are projected to decline by up to 50 bp over the next 18 months, lowering the coupon on the USD CLO and hurting the return. In contract, the EUR CLO coupon is already floored, and EURIBOR rates are eventually projected to rise (Exhibit 5);

Exhibit 5: Projected forward 3-month LIBOR and EURIBOR rates

Source: Bloomberg, Amherst Pierpont Securities

Also, projected forward exchange rate curves in USDJPY and EURJPY have remained the same shape but the levels have shifted (Exhibit 6).

Exhibit 6: USDJPY exchange rate curves

EURJPY exchange rate curves

Source: Bloomberg, Amherst Pierpont Securities

For the year ending on May 1, the US dollar appreciated 1.4% to the yen while the EUR depreciated 5.3%. The depreciation of the EUR versus the yen helps the projected return analysis for new investments because (1) new capital in yen is worth more euro and (2) the shape of the forward exchange rate curve stayed the same, which prices in a much slower appreciation of the yen versus the EUR than it does versus the USD.

These shifts in exchange rates and forward LIBOR and EURIBOR curves combined to give the edge to EUR CLOs versus USD CLOs, at least on a projected basis assuming forward rates are realized.

The longer view

While Japanese portfolios hold an estimated 10% of global CLO debt, according to the Bank of England, US banks hold 20% and US insurers nearly another 15% along with other US portfolios. If CLO spreads remain wide while other sectors tighten, the interest from dollar-funded portfolios should sharpen. Beyond issues of demand, the pipeline of supply trapped by wider loan spreads in the fall should dissipate over the next six months, further removing a drag on CLO performance.

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