European regulation requires companies issuing collateral loan obligations (CLOs) to retain a stake in these products, ensuring they share some of the risk alongside investors.
The regulation prevents most US CLOs from being included in UCITS funds, so ETFs targeting these bonds must instead focus on European CLOs, with issuers required to retain an interest in the bond, according to Roger Coyle, partner at Fair Oaks Capital.
Corporate credit manager Fair Oaks Capital became the first manager to launch a UCITS CLO ETF, which contains 100% exposure to European CLOs.
This ‘skin in the game’ rule was introduced post-2008 Financial Crisis to prevent poorly constructed products from being sold to investors.
While the US once had a similar requirement, it has since been relaxed, leaving most US CLOs ineligible for the European ETF market. As a result, UCITS ETFs in Europe face restrictions in including US CLOs in their baskets.
Coyle noted since the beginning of 2019, European investors need to comply with the securitisation regulation, which importantly contains the risk retention rule.
“This means the CLO manager, or a party that is involved in setting up securitisation, needs to retain a 5% interest in it which we call risk retention,” Coyle said.
He also noted there is a subset of around 15 to 20% of US CLOs that comply with European regulation, so these securities can be marketed in Europe.
Though this may seemingly impact liquidity, it is worth noting AAA European CLOs have greater liquidity than European high-yield bonds, a source familiar with the structure told ETF Stream, making them suitable to be wrapped in an ETF structure despite European regulations.
This is highlighted by the market being currently valued at $250bn and growing by approximately $30bn in new issuances each year.
Coyle added the liquidity of the US and European markets are largely identical, alongside the structure of the product. The inability to wrap US CLOs under UCITS is just one aspect of the complex regulatory landscape surrounding this type of bond.
For example, the jurisdiction the ETF is domiciled in will determine the amount of CLO exposure the ETF can have in its portfolio.
Luxembourg is currently the favourable domicile, spotlighted when Fair Oaks launched it's Luxembourg-domiciled ETF with 100% CLO exposure.
Despite the Central Bank of Ireland (CBI) currently capping CLO exposure at 20%, the CBI is set to approve UCITS funds with 100% CLO exposure, ETF Stream understands.
