When returns on safe assets are low, investors look for riskier places to put their money. In Japan, where yields have been near zero for some traders’ entire careers, an increasingly popular investment is bundled U.S. corporate loans known as CLOs, or collateralized loan obligations. Some observers have drawn parallels to the collateralized debt obligations, or CDOs, that helped turn packaged U.S. mortgages into bombs that laid waste to global financial markets in 2008. Japanese regulators have drafted a rule that could limit their risk -- along with a big exemption that will let the frenzy continue.
1. What are CLOs?
CLOs are securities made up of leveraged loans –- typically borrowings of companies with low credit standing. Investors buy the products in tranches of varying levels of risk. Japanese financial firms including Norinchukin Bank have been snapping up the highest-rated slices, which rank first for payments but get lower returns than the riskier portions.
2. Why are they popular in Japan?
Japanese banks have been buying CLOs and other securities abroad because the central bank’s ultra-easy monetary policy has made it extremely difficult to profit from domestic bonds and loans. They hold at least 10 percent of the $750 billion global market for CLOs, according to the Bank of England. The securities are particularly appealing for Norinchukin and Japan Post Bank Co., which have more deposits lying around than the country’s biggest commercial banks because of their limited lending ability. Norinchukin alone bought $10 billion of CLOs in the U.S. and Europe in the fourth quarter of 2018, almost half of all issuance for the period, according to estimates compiled by Bloomberg.
3. What are their dangers?
CLO defaults have been rare over the past two decades, but some observers worry that the products could be vulnerable during the next economic slump. High demand for the securities has raised concerns that the quality of the underlying leveraged loans may be falling. More and more leveraged loans lack covenants that protect creditors by restricting borrowers’ activities, increasing the risk of losses. And if investors suddenly sour on CLOs, banks may be stuck with unsold loans and credit markets could seize up, hurting the real economy. On the other hand, better-rated CLO tranches have greater protection than CDOs backed by subprime mortgages that sparked the global financial crisis, because higher levels of losses are required before they lose money.
4. What are the regulators doing?
Japan’s Financial Services Agency has stepped up scrutiny of large CLO investors. Officials are concerned that the banking system would be hurt if companies like Norinchukin suffered damage to their portfolios. The agency is also introducing a rule to penalize banks that buy CLOs from parties that don’t retain a stake in the underlying loans. But buyers can avoid the risk-retention rule if they prove the CLOs were created appropriately from assets in the so-called open market, rather than directly from the banks that made the loans.
5. What’s the outlook?
With no end in sight to the Bank of Japan’s negative interest-rate policy, Japanese banks are sure to keep taking risks abroad to secure returns. And even though attention from authorities is intensifying, the new regulations -- by sidestepping the risk-retention rule -- leave a window open for the largest Japanese firms to keep buying CLOs, according to analysts at S&P Global Ratings and SMBC Nikko Securities Inc.
--With assistance from John O’Neil.
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