September 12, 2019 - There have been the periodic comments that i) no one knows who owns CLO notes and ii) this might mean fire sales in a downturn. We want to tackle both these narratives head-on. To do so, we first review literature that reveals the owners of CLO notes and then we highlight recent analysis on how these holders likely will behave in a downturn. Spoiler: We know many of the holders and they’re unlikely to be forced to unwind positions.
There is considerable reporting on CLO ownership both in the aggregate and on an individual institution level. First, a recent Fitch report entitled “Leveraged Loans & CLOs in Financial Institutions” highlighted exposure by banks and insurance companies by region. Fitch noted that there was roughly $94 billion in CLO holdings by U.S. banks, an estimated $35 billion in holdings by European banks and around $113 billion in holdings by Japanese banks. Importantly, bank holdings are predominantly in AAA-rated CLO notes. Default risk is a very low probability; however, there could be downgrade risk or mark-to-market risk in CLO notes held in banks’ “Available for Sale” portfolio. We’ll return to this issue momentarily.
Fitch further reports that U.S. insurance companies have $122 billion of exposure to CLO notes, in the senior and “upper mezzanine” (e.g., investment grade) notes, while European insurers have less exposure to CLO notes. Meanwhile, in a recent “FEDS Notes”, Federal Reserve Board researchers parsed CLO securities ownership using data from SIFMA and the Treasury International Capital (TIC) system. Finally, the National Association of Insurance Commissioners recently published aggregate insurance company CLO holdings.
While the aggregate information is helpful, more granular information is, well, more helpful. First, LCD recently demonstrated that one can track individual bank holdings in CLOs through Form Y-9c reports. Second, Moody’s recently published CLO holdings of individual insurance companies, including attachment and detachment points (which can be correlated to the average rating of the notes). Thus, the argument that CLO ownership is opaque, murky and unmeasurable overstates the case.
So if we know who holds CLO notes, do we also know how these holders will behave if the market turns south? Perhaps. BAML recently researched the issue. Punchline: The nature of the holders – and the fact that most CLO note investors don’t employ leverage – suggests that CLOs are in the hands of longer-term and real-money investors that should not become forced sellers. This is key because, with extreme unlikeliness of credit losses and average coupons on AAA notes in the LIB+130 context today, they offer very attractive spread compensation, BAML notes.
This assumes, of course, CLO investors are not forced to sell at a mark-to-market loss at some point in the cycle. To assess the potential of forced sales by holders employing leverage, BAML tracked CLO BWIC and TRACE activity for the past several years, including during the energy-inspired sell-off in late 2015/early 2016. Even with CLO note mark-downs, there was no significant spike in BWIC or TRACE activity, suggesting limited forced selling – and perhaps little exposure by leveraged holders of CLO notes.
Could insurance companies or banks be forced to sell? Most likely not. While capital charges could increase for insurance companies if CLO notes were downgraded, the capital charges really begin to bite at the CCC level. Insurance companies, meanwhile, mostly invest at the AAA and AA level. As for U.S. banks, they do not use external ratings for capital charges, but instead use SSFA formulations which rely on attachment and detachment points. Because CLO AAA and AA rated notes have such high attachment points, loan delinquency rates would have to skyrocket for capital charges to increase meaningfully. Finally, Japanese banks, who are sophisticated holders of a considerable amount of CLO AAA paper, did not sell their notes even at the worst of the financial crisis.
Taken together, these data points suggest that, contrary to the narrative, i) we actually know who holds CLO notes and ii) they are unlikely to sell madly in an economic downturn.