If the Fed is looking for definitive proof of bubble euphoria it should look no further than the CLO market: according to Bloomberg, so far in 2014, more than $46 billion of collateralized loan obligations have been raised, after $82 billion were sold in all of 2013. As a result of this epic dash for repackaged trash, JPMorgan boosted its annual forecast for CLO issuance from $70 billion to as much as $100 billion, which means 2014 may end up as the biggest year on record. We assume it is with great irony that Bloomberg summarizes: "The business of bundling junk-rated corporate loans into top-rated securities is booming like never before after the implementation of regulation aimed at making the financial system safer."
The reason for the irony is that it was rampant CLO issuance which helped finance some of the biggest leveraged buyouts in history during the last credit boom: buyouts which in the subsequent year almost without fail flirted with bankruptcy as a result of overleveraed balance sheets and collapsing cash flows, which however found a second wind courtesy of the Fed's ZIRP policies.
Adding to the irony is that the 2014 CLO surge picked up following an early 2014 slump brought on by the publication of the Volcker Rule designed to limit risk-taking by banks which were major buyers of the funds.
This attempt to reign in risk-taking worked for a few months...
CLO sales plunged to $2.55 billion in January, the least since July 2012, according to RBS, following the December publication of the final draft of the Volcker Rule. The rule prohibits banks from investing in the debt of CLOs that own bonds.
Until a loophole was discovered:
After the market developed funds that adhered to the regulation, sales rebounded in February with $9.4 billion raised that month, RBS data show.
What happened next is not only history, it is on pace to become historic:
“The pending threat of risk retention has fueled the CLO-issuance fire,” said Wriedt. “Everyone has been highly motivated to come to market, which is why we are seeing such a plethora of deals.”
CLOs were the biggest buyers of junk-rated loans in the first quarter with 58 percent market share, the most since 2006 when they had a 61 percent share, according to a report from the LSTA, citing Standard & Poor’s Capital IQ Leveraged Commentary and Data. Retail funds came in second at 26 percent.
The deals helped propel issuance of new leveraged loans to $357 billion last year, the most on record, Bloomberg data show.
If JPM's prediction about $100 billion in CLO issuance is correct, 2014 will be an all time record year not only for CLOs but HY underwriting in general, as the yield on average "High Yield" bond drops to never before seen levels matched only by near-all time default lows.
For those lucky few who are not familiar with CLOs, here is a reminder:
CLOs pool high-yield corporate loans and slice them into securities of varying risk and return, typically from AAA ratings down to BB. 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.
Dodd-Frank knew that as a result of Fed's disastrous policies, there would be a yield scramble and tried to forestall the inevitable scramble into securitized junk:
“New regulations, especially the Volcker Rule, have had a significant impact on banks’ participation in this market and is the primary reason CLO AAA” spreads remain wide, Matthew Natcharian, head of the structured credit team at Babson Capital Management LLC in Springfield, Massachusetts, wrote in an e-mail.
CLO managers may also be trying to issue deals ahead of risk-retention rules proposed by the Dodd-Frank Act in order to increase assets under management and income, said Kroszner. The regulation may require CLO managers to hold 5 percent of the debt they package or sell.
Sadly, it failed.
To be Volcker compliant, managers are primarily choosing to issue CLOs that are prohibited from owning bonds or can only purchase the debt at a later date if the stipulation is changed.
While the Volcker Rule hasn’t led to fewer CLOs it has kept the cost to raise the funds elevated.
The average rate paid on CLO portions ranked AAA was about 150 basis points more than the London interbank offered rate in May, according to Wells Fargo. That’s up from a spread as low as 110 basis points on AAA slices last year.
But most amusingly, none other than the Fed has warned about the scramble for repackaged junk yield: "the growth in riskier corporate lending led the Federal Reserve and the Office of the Comptroller of the Currency to warn lenders last year to improve lax underwriting practices. Todd Vermilyea, a Fed official, said May 13 that standards “have continued to deteriorate in 2014” and that “stronger supervisory action” may be needed."
Unfortunately, since picking yield pennies in front of a steamroller is all that matters in determining year end compensation, this and all other warnings will be roundly ignored until it is too late. But who says it will ever be too late: surely this time it's different and this particular credit bubble will never burst.