By Takahiko Wada
TOKYO (Reuters) – Japanese banks have stepped up investments in highly illiquid, securitised loans, mostly in the U.S. market, as it becomes increasingly difficult to earn decent interest income from conventional products like government bonds.
A Reuters survey showed some of Japan’s biggest banks, led by Norinchukin Bank, have nearly doubled their investment in collateralised loan obligations (CLOs) in the nine months to December.
While the increased exposure brings back memories of similar, complex products made up of subprime mortgages that triggered a global financial crisis a decade ago, banks say they are managing risks carefully.
Moreover, analysts expect institutions to continue buying such assets as Japanese investors seek returns amid a zero interest rate environment at home and a shrinking pool of stable, high yield income abroad.
“We are controlling risks and returns from our major asset classes — bonds, stocks and credit products — by looking at their correlations and with proper checks by our risk control desk,” said a spokesman for the Norinchukin Bank, by far the biggest CLO buyer among Japanese banks.
CLOs are essentially an investment in a pool of loans to high-risk, low-credit companies. But not all investors share the same return and risk.
Those who invest in the “equity” part, typically up to 10 percent of the entire pool, enjoy very high yields but have to take losses from borrowers default first.
When defaults increase more than the equity investors can absorb, investors in “junior” tranches are next in line to suffer losses, followed by “mezzanine” tranche holders.
The rest, typically about 60-70 percent of the total pool, are called “senior” tranches and normally come with AAA credit ratings because their repayments are at risk only when the other three classes fail to cover losses.
That means they suffer losses only when more than 30-40 percent of loans default, an unlikely scenario even under a severe economic downturn, at least based on historical records.
All the Japanese banks Reuters contacted said they have bought only AAA tranches.
Senior CLOs are attractive because they typically yield about 100 basis points or more above U.S. Treasuries despite their high credit ratings.
The hefty yield spread is the premium issuers need to pay investors for holding illiquid assets.
“As long as we can earn appropriate spreads, we plan to deal with CLO issues that will be resilient to risks,” said spokesman at Sumitomo Mitsui Trust Holdings.
The size of securitised debt market shrank after the crisis. In the United States, it fell from over $1 trillion to around $600 billion in 2013. But since then it has gradually recovered to around $800 billion (£613 billion).
Market players say CLOs today are considered less risky than the notorious collateralised debt obligations, or CDOs, which caused a massive market shock in 2007-08 after subprime borrowers’ default jumped.
Regulations have become tighter since then and borrowers in CLOs are companies, whose financial records are easier to analyse for investors, rather than thousands of subprime mortgage borrowers.
Still, analysts say they cannot rule out the possibility that CLO prices would fall if an unexpected economic downturn prompted investor panic.
“When the economy deteriorates, we could have a vicious cycle of rising funding costs increasing defaults further,” said Yukichi Shimosato, market analyst at SMBC Nikko Securities. “And because the CLO market is illiquid, if investors pull out some money, the price of CLOs could fall to extreme levels.”
Graphic: Japanese banks’ holding of CLOs (https://tmsnrt.rs/2X2y2pp)
(Additional reporting and writing by Hideyuki Sano; Editing by Sam Holmes)