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Japanese Hunger for U.S. CLOs Exposes Market to More Volatility

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Collateralized-loan obligations in the U.S. ballooned to a record last quarter thanks in large part to unusually high demand from Japanese investors. But that influx has left the roughly $450 billion market exposed.

Japanese investors ramped up their interest in the market for top-rated slices of CLOs over the last year because their preferred hedging mechanism became relatively cheap. If that changes, watch out, said Laila Kollmorgen, a portfolio manager at PineBridge Investments based in Los Angeles.

(Related: Dead Malls Are Alive and Well in Wall Street’s CLO Debt Machine)

“If hedging costs increase, AAA-rated spreads will likely go the other direction as well,” Kollmorgen said. “When you have a significant buyer in Japan driving spreads down, that can go the other way, too.”

CLO demand from Japan helped propel new issuance to a record first quarter of $37 billion. The AAA yield spread over Libor narrowed more than 23 basis points in the past year, a move roughly mirrored in the dollar-yen five-year cross currency basis swap, which provides cover for the overseas investors. CLOs are the biggest buyers of leveraged loans, which fuel buyouts and provide funding to riskier companies.

The tightening AAA spread has been directly correlated to similar moves in the dollar-yen and euro-yen cross-currency basis swaps, according to Kollmorgen. As the relative cost of hedging has become less expensive, it has attracted Japanese investors, she said.

Thus, if a global event, such as when the talk of U.S tariffs sent stocks plunging in February, raises the cost of hedging for Japanese investors, the shock could rattle the CLO market.

“Japanese investors continue to be significant players — therefore, any move in rates and a resulting move in currency-adjusted yields can drive CLO AAA spreads,” Wells Fargo analysts led by Dave Preston wrote in a recent note.

But absent a major event, hedges should remain inexpensive, even with a rise in Libor partly offsetting the savings from a narrower basis swap. Currency hedging costs are expected to gradually decline throughout the year, increasing demand, Nomura analyst Pratik Gupta said in an interview.

The U.S. CLO market has attracted more interest from the Japanese this year as it’s now on par with Europe. Some shine came off the American market roughly a year ago when the euro-yen cross-currency basis made European investments more appealing. Now that has changed, with top-rated tranches of CLOs in both markets offering similar returns.

After the record-setting quarter for deals, a bit of fatigue has set into the CLO market and spreads have edged wider. A court ruling earlier this year that said the sector no longer has to comply with risk retention rules, which could boost supply from smaller managers, also weighed on the market. For these reasons, some investors are on the sidelines, but many are still positive.

“For CLOs, in addition to the pick-up in spreads, the default history is so good, that we often tell clients to look into CLOs when diversifying their portfolios,” Kollmorgen said.

—With assistance from Faris Khan.

— Read Citigroup Predicts Record $140 Billion of CLOs as Demand Deepens on ThinkAdvisor.

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