The primary collateralized loan obligation market has shifted cautiously into low gear, despite the fact that the rules of the road remain unclear.

The CLO market had hoped to escape unscathed, but the final version of the Volcker Rule bars U.S. banks from having ownership interests in securitizations backed by bonds or other securities.

Banks traditionally have been big buyers of collateralized-loan obligations and acted as lead arrangers of such transactions. The Volcker Rule and other new mandates involving risk retention and deposit insurance assessments are expected to affect banks' appetite for CLOs and how they structure their involvement in transactions.

Three outcomes exist for banks that hold senior tranches of CLOs backed by bonds, one of which would completely address the issue. While there is reason to hope that the best-case scenario will come to pass, caution rules on the new issue market.

"This is real time for us," says a CLO manager whose firm is planning to launch a deal in the near future. "For the time being, it's effectively no bonds."

The key word is "effectively," market participants say.

Most new issue CLOs include wording that allows for future bond holdings if regulators clarify certain Volcker language — specifically, whether the right of triple-A investors to replace or remove a manager for cause constitutes an "ownership interest."

Holders of CLO senior notes have manager-removal rights, so concerns exist that, under Volcker, triple-A investors will be considered to hold ownership interests. That leaves banks wondering if they will have to unload their CLO paper — up to $70 billion of senior notes — before the rule takes effect in 2015.

"For our next transaction, at present the proposed language includes a springing bond bucket which would be utilized only if it is deemed that investments in the debt tranches of the CLO are not considered 'ownership interests' as defined in the Volcker Rule," says John Popp, head of the leveraged investments group at Credit Suisse Asset Management.

Columbia Management Investment Advisers and Black Diamond Capital Management have also marketed deals with leeway to change the investment allocation to include bonds in the future, according to rating agency presale reports.

Here is a look at three outcomes for banks caught in limbo.

Outcome #1: The Big Fix

The clarification of the ownership interest language is what the Loan Syndications and Trading Association and other trade groups want. "This is a really easy fix as regulatory things go," says Elliot Ganz, the association's general counsel.

"It could be done in the form of an FAQ or a joint statement by the agencies," Ganz adds. "We're not asking them to exempt anything. If CLO investors have the right to remove or replace a manager for cause, all we're asking is that the agencies agree that that doesn't constitute an ownership interest."

Not only does this solution solve the problem for all CLOs, it represents reality, Ganz says.

"The agencies don't want … you [to] have what's called a debt security, but really it has all these elements of ownership that make it look like an equity," Ganz says. "We get that. All we're saying is the right to remove or replace a manager is not really an ownership interest. It's a protective provision."

There is bipartisan support in Congress for solving the problem, adds Ganz, who testified before the House of Representatives' Financial Services Committee at a Jan. 15 hearing, where representatives from both parties indicated a willingness to work with regulators.

When this might happen remains unclear.

Outcome #2: Grandfathering

Speculation centers on another solution: exempting or grandfathering existing CLOs. Since regulators decided in December to exempt certain collateralized-debt obligations holding trust-preferred securities, industry observers have theorized that the same could happen with CLOs.

This outcome would be far better than no exemption, but it could create a market bifurcation, with banks — key triple-A investors — limited to buying new issue CLO paper, while demand for secondary paper would be limited to asset managers and others not affected by Volcker.

If this happens, analysts expect banks to attempt, on a deal-by-deal basis, to work with managers to remove bonds from existing CLOs. They would also expect CLO equity holders to push back, as bonds can provide value to equity tranche owners, especially during times of volatility, and as assets to purchase just prior to the reinvestment period conclusion.

"Taking away the ability of a manager to invest in other asset classes takes away optionality they've traditionally had," says Kenneth Kroszner, CLO analyst at Royal Bank of Scotland. "It eliminates a way to express relative value between loans and bonds, which could ultimately limit equity returns."

Market participants agree that, if holding bonds remains problematic for new CLOs, managers will deal with the issue of equity returns by buying more second-lien loans. Some believe the difference between high-yield bond returns and second-lien returns will be minimal over the next several years, given where interest rates appear to be headed.

"We're in an environment where the expectation is that interest rates will increase over the next five years, it's just a matter of how much," says Steven Oh, managing director of global credit and fixed income at PineBridge Investments.

"I don't think we'll see the same outperformance of high-yield bonds going forward that we've seen historically," Oh adds. "So putting bonds in your portfolio does not necessarily mean you'll have a better outcome, especially if interest rates rise in a meaningful way."

CLO managers could face stiff competition for second-lien loans. In a Jan. 31 note to clients, analysts at Barclays predicted that the imbalance of supply and demand for second-liens to be "even more extreme" than it will be for first-lien loans.

While some deals cannot own any second liens, many are able to own up to 10%, and the average post-crisis CLO deal "has a bucket of 5.5%," the analysts wrote. "Therefore, similar to the overall loan market, CLOs could own up to half the almost $27 billion second-lien loan market.

The analysts stated that CLOs have not traditionally allocated as much to second-liens as they could, and they are likely to take full use of second-lien buckets if forced to abandon bond holdings because of the Volcker Rule's definition of ownership interest.

Another issue with eliminating bonds has to do with fixed-rate liabilities: some CLOs with big bond buckets issue a tranche of fixed-rate notes to better match interest payments with the collateral's cash flow. "It's not a large percentage of the CLOs, but many do have fixed-rate liabilities," Kroszner says.

"Equity holders in these transactions face disproportionately higher funding costs due to the current steepness of the yield curve," Kroszner adds. "Without fixed-rate high-yield assets to offset these costs, equity yields may shrink. In addition, there will always be an inherent mismatch between floating collateral and fixed liabilities, which may present its own issues down the line."

Outcome #3: No Change, Sell-Off Ensues

The third possible outcome, which appears to be the least likely, is that regulators do nothing — no language clarification, no grandfathering — and banks are forced to divest CLO holdings. Though not all existing CLOs hold bonds, nearly all of them have the ability to and, without control over a manager's future investment decisions, banks would likely get out entirely.

There was a bid wanted in competition that came out within a week of the publication of the final Volcker Rule from a regional bank selling all of its triple-A paper, market participants say. More of this would be disastrous for the CLO market.

Selling would put downward pressure on CLO prices and could trigger more pressure to sell, Ganz told the House committee, potentially causing a downward spiral of prices and further sales, despite no fundamental changes in the projected cash flows of the underlying CLO debt security.

The good news, at least, is that lawmakers seem to be listening.

Carol J. Clouse is a freelancer based in New York.

This story originally appeared on

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