Volcker rule could kill reemergence of CLOs

Morgan Stanley cut its collateralized loan obligation forecast by as much as 27 percent to $55 billion as issuance slowed last month because of questions about the Volcker Rule’s impact on the funds that finance buyouts.

Five new-issue U.S. CLOs for $2.55 billion were sold in January compared with 17 transactions for $9.04 billion in the same month last year, Morgan Stanley said today in a report. The New York-based bank lowered its 2014 forecast to $55 billion to $65 billion, from its initial projection of $65 billion to $75 billion, according to the report.

Issuance of CLOs surged 49 percent last year to $82 billion, the most since 2007, when $92.8 billion were arranged, according to Royal Bank of Scotland Group Plc. A lack of “enthusiasm” from AAA investors, the largest portion of a CLO, because of the Volcker Rule’s unknown effects has led to a slowdown in the pace of new issuance, Morgan Stanley said.

“The most notable aspect of the CLO market has been lackluster new issuance year-to-date, driven mainly by Volcker Rule uncertainties,” analysts led by Vishwanath Tirupattur wrote in the report.

CLOs pool high-yield loans and slice them into debt securities of varying risk and return, typically from AAA ratings down to B. The lowest portion, known as the equity tranche, offers the highest potential returns and the greatest risk because investors are the first to see their interest payouts reduced when loans backing the CLO default.

Tightening Spreads

CLO sales of deals backed by widely syndicated loans plunged to $1.22 billion in 2009, the year after the collapse of Lehman Brothers Holdings Inc. precipitated the biggest financial crisis since the Great Depression, according to Morgan Stanley data.

Spreads on existing AAA CLO debt fell to 110 basis points in December from a 2013 high of 130 basis points during the first quarter, according to Morgan Stanley data. They rose to as high as 725 basis points in April 2009 from a nine-year low of 23 basis points in 2007. A basis point is 0.01 percentage point.

“The CLO new-issue market may remain sluggish until there is regulatory/legislative relief from Volcker for existing holdings of CLO tranches for banks or until clarity emerges about the way forward for resolving Volcker compliance,” the analysts wrote.

Under Volcker, banks would not be able to own debt of CLOs that are invested in bonds or other securitized products. Industry groups including the Loan Syndications and Trading Association submitted a proposal with alternatives to regulators to clarify the language around ownership, according to the report. An Interim Final Rule for Volcker released Jan. 14 didn’t provide any clarification or a reference to CLOs, Morgan Stanley said.

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