Home ListingApril 9, 2014

Managing Regulatory Risks on Leveraged Credit

With the Volker Rule, risk retention rules, and more than two-thirds of CLOs reaching the end of their reinvestment period in three years, how should investors prepare?

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(April 9, 2014) — CIO Scott Minerd’s team at Guggenheim Partners has identified the biggest regulatory risks for the leveraged credit market—and how to mitigate them.

In a white paper on the outlook for high yield and bank loan outlooks, Guggenheim Partners stated that while the leveraged credit market was likely to outperform until default rates begin to rise in late 2016 or 2017, there were three key risks investors should be aware of.

The first was the eventual impact of the Volker Rule regulations, introduced by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Under the regulatory guidance, banks will no longer be able to own collective loan obligations (CLOs) that contain non-loan investments, such as high yield bonds. Data from Thomson Reuters suggested only 31% of US CLOs would comply with the rules today, meaning banks would be prohibited from holding 69% of the CLO market—equating to almost $200 billion.

A forced sell-off would drive CLO spreads wider and stall new issuance, Guggenheim said. However, issuers became savvy to the rules in 2013, and new Volker-compliant structures which contained no bonds began to appear, known as CLO 3.0.

In addition, the date by which banks would have to comply has been pushed further out: originally banks would have had to be Volker-ready by July 2015, but the Federal Reserve delayed the implementation deadline until July 2017, making widespread selling less likely.

The second major concern for investors cited by Guggenheim was around the risk-retention rules introduced under Dodd-Frank, which are expected to be finalised this summer.

Under the existing proposals, the rules would require CLO managers to hold 5% of each CLO they issue. This, Guggenheim said, could cause major problems, given many of the CLO managers and frequent issuers may not have enough capacity on their balance sheet to hold this 5%, potentially hampering new issuances.

“Our research also shows that the schedule of current CLOs exiting its reinvestment period makes continued CLO formation necessary to mitigate bank loan defaults in 2017,” the paper said.

Which leads on to the third problem: the biggest risk according to Guggenheim is that in 2017, 69% of the current CLO market will have reached the end of its reinvestment period.

To recap, CLOs have a pre-determined period, usually two or three years, after which they can reinvest their proceeds into additional loans. After that reinvestment period ends, the CLOs have to use their proceeds to pay down the debt, reducing inflows into the market.

“The combined effect of a weak CLO primary market and an amortizing secondary CLO market would be a significant decline in loan demand when coincidentally, 15% of the loan market matures and may be looking to re-extend debt to avoid principal defaults,” Guggenheim explained.

The question then is what will happen if those maturing loans that need to re-extend their debt hit a rising rates market and a smaller investor market?

Guggenheim has come up with three strategies to help insulate portfolios from these future risks. The first is to focus on investments that are less likely to be caught up in large waves of sell-offs.

Avoid bonds that make up a large percentage of an ETF or that are held across multiple ETFs, Guggenheim advised, as they were more likely to suffer severe price declines when fast-moving accounts experienced sell-offs by multiple investors.

Secondly, opt for smaller, high-yield bonds and bank loans that offer significantly bigger yield pickups than larger deals.

“In select transactions, investors have the ability to drive deal terms, an opportunity generally not available in larger debt offerings,” Guggenheim said.

“Also, during short-term selling periods, larger, more liquid bonds are typically liquidated first as mutual funds and ETFs try to meet redemptions.”

Thirdly, investors should seek to spread the maturity profile of their credit portfolios. A barbell strategy was selected as optimum by Guggenheim, as it allows investors to structure a portfolio with both long and short-term securities, helping to avoid the concentration of maturities in credit investments in any one year and mitigating principal default risk.

The full paper can be found here.