Large and regional banks had ramped up their holdings of floating-rate collateralized bond obligations in 2021 and again in 2022—if at a slower pace—as the Federal Reserve pursued aggressive rate hikes. In the first half of 2023, however, their holdings languished even as interest rates continued to climb, a pause that may prove temporary as the year progresses.
Regional banks' holdings of collateralized loan obligations (CLOs) increased rapidly in 2022, to $14.3 billion. That represents a by 41.6% increase from $10.1 billion, after more than tripling from $3.0 billion at the start of 2021.
So far in 2023, however, the level of all banks' CLO investments has hardly budged, despite the benefit of holding the floating-rate securities as the Fed continues to raise rates. In Q1 2023, regional banks' CLO holdings actually increased slightly, to $14.7 billion from $14.3 billion, according to Form Y-9C filings analyzed by Bloomberg, then fell back to $14.5 billion in Q2, in the wake of Silicon Valley Bank (SVB) and Signature Bank entering receivership.
The eight Global Systemically Important Banks (GSIBs) increased their CLO holdings in 2021 by a much smaller multiple of 49.7%, although their absolute increase of $33.2 billion far exceeded the 24 regional banks' $7.1 billion during that period. In 2022, the GSIBs' CLO growth slowed, increasing by 14.7% to $114.7 billion from $100.00 billion. By the end of Q2 2023, the GSIBs' total actually dropped slightly, to $114.5 billion, according to Bloomberg.
CLO divergence
The factors prompting lower investments in CLOs between regionals and GSIBs differ somewhat and may determine when, and to what extent, they boost CLO investments in the foreseeable future. In 2022, regional banks saw deposits slipping away as bank customers sought higher yields elsewhere, reducing banks' capital to invest in assets such as CLOs.
Meanwhile, rapidly rising rates slashed the value of banks' highly rated fixed-income investments, resulting in a few highly publicized bank failures and increased investor scrutiny of other regionals. More floating-rate CLOs on their balance sheets would have mitigated at least some of that fixed-income risk.
"If they had just held 'AAA' CLOs instead of other asset-backed securities (ABS), such as residential mortgage-backed securities (RMBS), they would have been in better shape," said Daniel Wohlberg, principal at Eagle Point Credit Management.
As jitters about the health of the regional bank sector subsides, he said, "You're starting to see regionals come back, and in their resurgence, as they're putting money to work, they're looking into structured credit."
Besides mitigating the risk of rising rates, CLOs are attractive to banks because the structured transactions' range of safety mechanisms have resulted in minimal losses since the Great Financial Crisis, even for lower-rated tranches. And the significant premium compared to comparably rated debt will remain attractive from a yield standpoint when rates eventually fall.
The GSIBs' CLO investments this year have been stymied in part by higher capital charges imposed on most of those institutions by regulators that went into effect starting last October.
If they had just held 'AAA' CLOs instead of other asset-backed securities (ABS), such as residential mortgage-backed securities (RMBS), they would have been in better shape
Overall, banks' CLO investments were essentially flat in the first two quarters of 2023 compared to a 13.0% increase over the same period last year. Sam Geier, senior credit strategy associate at Bloomberg Intelligence, attributed the noticeable year-over-year slowdown in the growth rate to regulators' tightening capital requirements on the big banks as well as the collapses of SVB and other large regionals earlier this year.
In fact, none of the GSIBs changed their CLO holdings significantly in the first half of 2023, and most regionals increased or decreased their holdings marginally, according to Bloomberg. The most significant change was NexBank Capital's $642.3 million CLO purchase in the last quarter of 2022—its first ever—that it increased to $1.45 billion by the end of 2Q 2023. More banks may follow.
"With conditions for banks calming down and CLOs providing attractive yields, you could see those CLO holdings start to pick up again over the next couple of quarters," Geier said.
New issue challenges
One impediment for banks interested in CLOs, however, may be new-issue CLO volume, which slowed in the Q2 compared to the relatively strong first quarter. In a recent report, Capital One attributed the lackluster Q2 to a light supply of new leveraged loans, an elevated cost of funds, and a changing investors base.
Part of the changing investor base may be regional banks shifting their investments away from 'AA' CLOs, where they have been significant investors. Edwin Wilches, co-head of securitized products at PGIM Fixed Income, said that while GSIBs tend to invest entirely in 'AAA' CLOs, the CLO banking teams his group speaks to have attributed as much as 30% of 'AA' CLO tranches to regional banks in recent years, with one bank owning upwards of $3 billion. That may no longer be the case.
"That may be a reason why 'AA' tranches [have been] some of the hardest tranches to place for a new issue [CLO], because that market is really missing those regional banks," Wilches said.
Wilches said regional banks have options besides CLOs to increase their floating-rate exposure, such as real estate lending. The banks may also be investing more in 'AAA' CLOs, which pay somewhat less than 'AAs' but are less volatile, and middle-market CLOs that securitize private credit and offer more attractive returns. Capital One noted that while overall new CLO issuance has declined, middle-market CLO issuance reached new highs in the first half.
Looking ahead, 'AAA' CLOs may become more attractive to banks of all sizes. The banking regulators proposed on July 27 to revamp banks' risk-based capital requirements. Barclays notes in an August 7 report, "Capital Conundrum," that under the proposal's new Securitization Standardized Approach (SEC-SA), the minimum risk weight for certain highly rated assets would decrease to 15% from 20%.
Those assets include CLO senior 'AAAs' and several other securitized assets, including private student loan ABS senior 'AAAs', and conduit CMBS LCF senior 'AAAs'.
As written, the proposal could help the largest banks offset their higher capital requirements. The proposal also replaces the two current approaches banks can choose from to calculate risk-based capital with a less complicated formula that puts regional banks on the same footing as the largest banks to obtain the most favorable capital treatment.
"While this proposal may marginally increase RWA related to credit risk for non-agency securitized senior notes [such as 'AAA' CLOs] for [larger] banks, it may incentivize smaller banks to participate more in the non-agency securitized senior notes market," the report says.
