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Japanese banks warned of COVID-19 impact on overseas CLO investments

Japanese banks, among the world's largest buyers of collateralized loan obligations, should be cautious about their holdings of such securitized products as default risk of underlying loans could be rising, albeit still low, amid prolonged pandemic disruptions globally, experts say.

Although rising risk aversion have pushed prices of CLO notes down in the secondary market, which has led to unrealized losses for CLO investors worldwide, the Japanese banks are in a relatively better position, at least in the near term, as most of the notes they hold are rated AAA, experts add.

Lenders in the world's third-largest economy have been buying overseas credit products as a hedge against ultralow interest rates and slow loan growth at home. The outstanding CLO holdings at 13 major Japanese banks nearly tripled between March 2016 and September 2019, the Bank of Japan told S&P Global Market Intelligence.

As of March 2019, the latest data available, financial institutions in Japan, mostly banks, collectively held 18% of the US$760 billion global CLO market, according to a June 2020 report by the Bank of Japan and Financial Services Agency. It also said almost all of the CLO holdings by banks were rated AAA.

The Japanese banks "are fine for now because global central banks are supporting businesses by providing ample cash," said Toyoki Sameshima, a senior analyst at SBI Securities Co. "But if the epidemic interruptions are prolonged, it's uncertain if such support will continue," potentially increasing the bankruptcy risk of borrowers of the underlying loans.

As of September 2019, the latest data available, 13 major Japanese banks collectively held ¥13.8 trillion of overseas securitized products backed by multiple loans to borrowers with relatively high leverage and low creditworthiness, according to the Bank of Japan. It was up from ¥5.1 trillion as of March 2016.

More than 99% of CLOs they held were rated AAA, compared with 77% for U.S. banks and 50% for U.K. banks, the report said. It added that the Japanese investors are likely to hold those products to maturity.

"However, given the grim prospects for the domestic profit environment, it is reasonable to assume that major banks will renew their commitment to overseas investment and lending. ... This deserves careful deliberation while fully taking the risk of the double dip into account," the report added.

Top investor cuts holdings

Japan's top CLO investor, Norinchukin Bank, told a press conference in May that it would refrain from investing in more CLOs.

The bank, which manages assets for farms and fishing cooperatives, held ¥7.7 trillion of CLOs as of March 2020. It was down from ¥8.0 trillion as of end-2019 but up from ¥7.4 trillion in March 2019.

Although default risk of CLOs appears low for now, rising risk aversion among investors had led to an unrealized loss of about ¥400 billion of its CLO portfolio in the March-end quarter.

"Of course, there is the big risk of their [the Japanese banks'] CLO investments," said Makoto Kikuchi, CEO at Myojo Asset Management Co. "Chances are high that even highly rated bonds will be downgraded," hit by recessions due to the prolonged Covid-19 interruptions.

S&P Global Ratings recently forecast that the U.S. trailing-12-month speculative-grade corporate default rate will likely increase to 12.5% by March 2021. But if COVID-19 cases resume their rise later this year or early next year, the default rate could go up to 15.5%.

JPMorgan, meanwhile, predicts a default rate for leveraged loans to just below 10% by the end of this year.

Those two forecasts imply a sharp rise from the current levels. As of end-June, the default rate by amount on S&P/LSTA Leveraged Loan Index stood at 3.23%, a five-year high, according to LCD, an offering of S&P Global Market Intelligence focused on leverage finance. The default rate by number of issuers was at near 10-year high of 3.7%, LCD adds.

"Risk to AAA CLO holdings, which are primarily what banks hold, seems relatively low. ... 58% of underlying leveraged loans would need to cumulatively default before they see losses of principal," assuming a recovery rate of 40%, Vivek Juneja, large-cap bank analyst at JPMorgan, wrote in a June 24 note.

Takahide Kiuchi, executive economist at Nomura Research Institute, added: "If there is any change of an economic picture, potentially by the second round of the epidemic effects ... even some of Japanese banks may unload their highly rated holdings."

As of July 1, US$1 was equivalent to ¥107.45.

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