The flourishing market for collateralized loan obligations has come under increasing scrutiny of late by U.S. lawmakers and regulatory agencies who say they are concerned that the $700 billion in outstanding CLOs potentially could pose considerable risks to the broader financial system. Some have even equated the market segment to collateralized debt obligations/mortgage-backed securities, widely cited as a major contributor to the 2007-2008 financial crisis.
CLOs are special-purpose vehicles set up to invest in, hold and manage pools of leveraged loans. Their popularity has skyrocketed over the past decade, along with the broader U.S. leveraged loan market, which now totals a record $1.2 trillion, according to LCD.
Specifically, observers are asking how much of those CLO outstandings are held by banking institutions, compared to the amount held by the "shadow banking" system of insurance companies, asset managers, hedge funds and other credit funds.
Lawmakers and regulatory agencies have expressed concern over whether enough data even exists to track the holders of CLOs.
"We know $90 billion of the $700 billion in CLOs (or 13%) is held by U.S. banks, but what do we know of the remaining 87%?" one lawmaker asked during a recent Congressional hearing about systemic risks in leveraged loans and CLOs.
While full transparency on a private credit market such as leveraged loans can be difficult to obtain, a window into who is holding those CLOs is possible through a combination of public filings, call reports by regulators to U.S. banks, as gathered by S&P Global Market Intelligence, and data from Citi Research.
Banks remain big AAA buyers
Starting at the top tier of the CLO structure, banks comprise some 45% of the buyers in AAA-rated tranches of newly issued CLOs this year, while money managers make up 30% and insurance companies 20%. Mutual funds and pension funds account for less than 5%, according to Citi Research analyst Maggie Wang.
Lower in the capital structure, for mezzanine tranches, money managers and insurance companies make up the lion's share of buyers, at 40% and 30%, respectively.
And in the equity portions of outstanding CLOs, more than 80% is held by asset managers. Wang attributes this to the necessity for CLO managers to retain equity on deals they issue. The CLO arbitrage, after all, has become more challenging, which has led to lower returns to equity holders, all else equal.
It is useful here to have some background. A CLO sells tranches of debt in the form of notes and finances the interest payments on those notes via the yield from the leveraged loans that the CLO has bought. The interest payments are the cost of a CLO's liabilities. The arbitrage is, simply put, the yield from the loans minus the cost of the liabilities.
By comparison, in 2018, asset managers made up about 40% of the equity buyers, while hedge funds made up closer to 20% and structured credit funds 25%.
Japanese banks grow AAA holdings
Japanese banks have become some of the most active buyers of AAA-rated CLO paper, as CLOs are one of the few such highly rated assets that help the banks approach a targeted return of 1%. The 20-year negative interest rate policy from the Bank of Japan has sent yields elsewhere well below that.
For instance, the 10-year Japanese government bond currently yields –0.13% while a 10-year U.S. Treasury bond, after currency hedging, yields –0.65%. And a recent "high-yield" bond issue for Aiful Corp. due in 1.5 years that was rated BB by a local rating agency and priced with a coupon of 0.99%.
Norinchukin Bank, a cooperative for farmers and fishermen, has notably built a global portfolio of $68 billion (¥7.4 trillion) in CLO paper, up from $62.6 billion (¥6.8 trillion) at the end of 2018 and $35 billion (¥3.8 trillion) a year earlier. Its CLOs in the U.S. and Europe make up some 7% of its total investment portfolio.
Behind Norinchukin, Japan Post Bank Co. Ltd. holds $10.6 billion in CLOs while MUFG Bank Ltd. holds another $1.6 billion. All of the banks' holdings are limited to the senior-most AAA tranche of a CLO.
More broadly, the Japan Financial Services Agency, or J-FSA, has taken note of the growing holdings of the banks and has required all of them as of April 1 to provide more information on their due diligence processes. The J-FSA is attempting to ensure that the CLO manager is analyzing the different covenants and other investor protections. It is also looking to determine that the CLO manager is not also the originator of the underlying loans of any transaction in which it retains risk. The goal is to thwart the risks associated with some of the precrisis originate-to-distribute models.
Those regulations appear to have had an effect on the banks.
At one point in January, following a volatile end to 2018, a handful of Japanese banks were the only buyers of new CLO AAAs. The AAA tranche makes up about 60% of a CLO's total financing costs.
The rest of the AAA buyer base, composed primarily of banks and money managers, has returned. Over the past few weeks, Japanese banks have dialed back their purchases, possibly in an effort to prove to the regulator that the market can continue to function without such oversight.
CLO managers that normally may have sold a sizeable portion of the AAA tranche to the Japanese banks have instead sold to a number of buyers across the U.S. and Europe, including the treasury groups of some of the largest U.S. banks.
US banks hold about $90 billion
Banks in the U.S. collectively have amassed about $90 billion of CLO holdings, as previously highlighted by Fed Governor Lael Brainard at a presentation for the Peterson Institute for International Economics in December.
Wells Fargo & Co. is the largest domestic bank buyer of CLOs, holding $34.6 billion, or about 2% of its total assets, followed by J.P. Morgan & Co. Inc. at $20.5 billion and Citigroup Inc. at $18.1 billion. Other banks, including Stifel Financial Corp., Bank of New York Mellon Corp., TD Group Holdings LLC, State Street Corp., BankUnited Inc., PNC Financial Services Group Inc. and Banc of California Inc. have CLO holdings topping $1 billion.
Insurance companies hold $122 billion
Insurance companies have also been taking a more prominent role in the CLO buyer base since 2016. As of the end of 2018, these concerns collectively owned about $122 billion, according to the National Association of Insurance Commissioners, or NAIC.
Among the different insurers, life insurance companies held the majority, at $94 billion, followed by property and casualty insurers, at $24 billion, and health insurers, at $3.5 billion.
And as analysts at Moody's wrote last week, purchases have grown rapidly, with life insurers buying over $14 billion in the second quarter of 2018, compared to purchases that were less than $1 billion per quarter leading up to the third quarter of 2016. The pace of buying has slowed since the highs, to about $11 billion in the third quarter of 2018 and $10 billion in the fourth quarter of 2018.
Of the insurance company holdings, 35% are rated AAA, 14% AA, 9% single-A, 8% BBB and 2% BB, while 32% were unrated, says Moody's.
Firms such as Reliance Standard, Fidelity & Guaranty Life and Global Atlantic have the highest CLO holdings as a percentage of their cash and investable assets. They range from nearly 15% for Reliance Standard to a little over 10% for Global Atlantic.
U.S. life insurers with the greatest total CLO holdings, by book value, otherwise were Prudential Financial at $6.9 billion; MassMutual with $6.6 billion; Global Atlantic with $5.5 billion; MetLife with $4.5 billion; New York Life with $3.6 billion; Great American Life with $3 billion; and Fidelity & Guaranty Life at $2.8 billion, according to S&P Global Market Intelligence.
CLOs are not CDOs
It has been over 10 years since the financial crisis, and levels of corporate and securitized debt have grown quickly since then, leading to more concerns about the potential risks to the financial system.
To be sure, terms on leveraged loans have been getting more aggressive, and many of those loans — about 60% by LCD's estimate — are being packaged into these CLOs. These are then purchased, in large part, by overseas investors, reminding many of the pre-2008 CDO machine, the end of which saw some tens of billions of dollars in losses across the financial system.
Yet part of the reason why a number of banks, insurance companies and other investors have been comfortable building their holdings in CLOs is that these vehicles performed astoundingly well during the financial crisis, compared to the similar-sounding CDOs, which were often filled with fraudulently underwritten subprime mortgages.
For example, no AAA or AA rated CLO has lost principal so far, with only 0.1% of single-A tranches, 3% of BBB tranches and 6% of all BB rated tranches taking losses, according to Moody's. In comparison, 43% of CDO tranches originally rated AAA ended up taking losses, a number that would jump to nearly 63% for tranches originally rated BB.
However, while few who focus on the market expect the same magnitude of calamity regarding the end of the current credit cycle, losses could still be meaningful, as leveraged loan investors' protections have been whittled away.
Famously, most of the $1.2 trillion U.S. leveraged loan market is now covenant-lite. By last check, cov-lite accounted for 79% of loans in the S&P/LSTA Leveraged Loan Index, and many market participants have conceded that going forward, the recovery rates on defaulted loans will be lower than the approximately 70% historical recovery rate on first-lien secured loans.
Still, a significant number of loans would need to default before any of the senior CLO tranches take principal losses. As research analysts at Wells Fargo, led by David Preston, have shown, assuming a lower recovery rate of 65%, 36% of loans would have to default before the single-B tranches start to take principal losses. That number jumps to 42% for BB tranches and 55% before the BBB rated tranches take a loss.
The U.S. leveraged loan default rate now sits at 1.24%, according to LCD. The historical average is 2.93%. The default rate peaked at 10.81% in November 2009.
This analysis was written by Andrew Park, who covers CLOs for LCD.
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