2017 has been a surprisingly good year for the Cayman Islands in terms of capital markets activity with year on year issuance levels in several key sectors of this market significantly up on prior years. This increase in activity has been somewhat of a surprise given major headwinds on the regulatory front, both in Europe and the US.
The US market in particular continues to see the Cayman Islands as the jurisdiction of choice for most types of non-domestic US securitisation, be it in the collateralised loan obligation ("CLO"), commercial real estate ("CRE"), aircraft portfolio securitisation or cat bond space. There also continues to be activity in several sectors out of parts of Europe and Asia, mostly in the form of repackaging transactions that issue notes into the capital markets.
As at the end of October 2017, US CLOs, the largest securitisation sector that consistently uses Cayman Islands special purpose vehicles ("SPVs") to securitise US corporate and middle market loans, mainly to non-investment grade US corporates such as Sealy Tempurpedic, American Airlines and Sprint Communications, had issued or priced of over US$95 billion of paper. At this pace, aggregate issuance volume for 2017 is on track to significantly exceed 2016 levels of US$97 billion which itself is the second highest issuance level, bettered only by the US$127 billion issued in 2015. What makes this number even more astonishing is that 2017 has been the single busiest year on record by some margin for refinancing and resetting of existing CLO transactions.
These 'refis' and 'resets' alone have been responsible for an additional US$140 billion of issuance in the US CLO space through the end of October. The principal driver for the continued refi/reset activity is the significant reduction on the CLO debt coupon during the course of 2017 which, in turn, helps increase equity returns and has attracted new investors into the space. At the start of the year, the average spread reduction on AAA tranches being refinanced was around 24 bps, but by July that reduction had increased to 33 bps and continues to increase as we head towards the end of 2017. The uncertainty around the CLO space in 2016 was driven, in large part, by the introduction of the risk retention regime in the US on 24 December 2016. Although not an 'originate-to-distribute' product, CLOs were tarnished with the same brush as CDOs, their infamous cousins that caused many of the losses during the credit crunch.
All this in spite of the fact that CLOs performed through the credit cycle and historic losses on securities issued by these entities is far lower than any equivalent rated assets other than Treasury securities (which have much lower returns). The US Dodd Frank legislation introduced a requirement for US CLO managers to have 'skin in the game' and to hold a 5% interest in the CLOs that they manage (in one form or another). In 2016, the market was pessimistic about the regulatory burden of complying with this regime and pundits predicted that many managers would face consolidation or be driven out of business or simply unable to set up to facilitate risk retention.
One year on, however, and the reality is entirely different. Managers and their legal advisers have come up with efficient risk retention structures, such as capitalised majority owned affiliate vehicles, that often utilise Cayman Islands funds somewhere in their structuring, and capitalised manager vehicles, that have enabled managers to bring third party funds into the equation to some extent and reduce the actual amount managers have to deploy. Interestingly, this also appears to have given the CLO market more credibility in the wider capital markets and, coupled with consistently attractive and safe returns, this has led to a large influx of new investors as well as a raft of new CLO managers. Other sectors of the capital markets where Cayman Islands SPVs have continued to see activity in 2017 include various types of repackaging programmes. Diversified payment rights transactions ("DPRs"), which are typically set up as programme vehicles to securitise bank remittances for emerging country banks, have continued to see solid issuance in 2017 as have traditional Euro medium-term note ("EMTN") programmes, although not at such high levels as in 2016.
Turkey is popular for DPR deals and Japan continues to be the most active market for EMTN issuance and that held true this year. We have seen a big uptick in companies being set up to repackage AAA notes issued by US CLOs.
Typically, these repack vehicles purchase US dollar denominated AAA notes and issue JPY Yen notes to Japanese domestic banks. The issuer will typically enter into a swap to hedge any currency risk. These enable Japanese regional banks, which cannot otherwise purchase US dollar denominated securities, to participate in the US CLO market.
Furthermore, CLO structures were used in 2017 to securitise commercial real estate loans in the US in the form of CRE CLOs, with a reasonably active issuance level, and also to fund infrastructure projects with that sector set to see growth in the future.
There is even talk of trying to use CLO technology in the aircraft securitisation space, an area which has seen huge growth over the past couple of years and which is set to continue growing given projected aircraft deliveries over the next 5 to 10 year time horizon.
As previously mentioned, the aircraft securitisation sector is worthy of note for its performance in 2017.
A trend that has really picked up momentum in the aircraft finance space is the increased use of alternative sources of funding to traditional bank debt, particularly transaction structures that allow airlines and lessors to access the capital markets.
Since 2014, there have been a substantial number of asset-backed securitisation ("ABS") platforms structured using Cayman Islands-incorporated, Irish tax resident issuers to issue notes, the proceeds of which are used to acquire an underlying portfolio of aircraft.
Even where these aircraft ABS issuer vehicles are not incorporated in the Cayman Islands, issuers are taking advantage of the flexible and user-friendly listing regime of the Cayman Islands Stock Exchange (the "CSX") to list the notes and other securities. ABS deals are usually structured by lessor companies, as opposed to airlines.
Airlines, however, are also accessing the capital markets by issuing enhanced equipment trust certificates ("EETCs") to finance the acquisition of new aircraft. Historically, these have been US domestic airline deals, but recently non-US airlines have launched EETCs, a number of which have featured Cayman Islands SPVs.
Development of these non-US EETC structures has been assisted by the widespread adoption of Alternative A of the Cape Town Convention (also adopted by the Cayman Islands), that closely resembles section 1110 of the United States Bankruptcy Code. Furthermore, a number of airlines have also established airline ticket and cargo sales securitisation platforms featuring Cayman Islands issuers.
In summary, 2017 has been an excellent year for the Cayman Islands capital markets product with record breaking activity in a number of areas. Leading the way is the CLO market with activity on multiple fronts including new issuance, refis and resets, repacks, and risk retention compliance, not to mention increasing listing work on the CSX as a result of the introduction of revised market abuse regulations in Europe (see article "Cayman Islands Stock Exchange – The Impact of the European Market Abuse Regulation" by Scott Macdonald for further details).
Other areas of note include aircraft securitisation and commercial real estate securitisation transactions. Given that the US is looking to roll back some of the Dodd Frank legislation including, by all indications, some of the risk retention provisions affecting the CLO market, 2018 looks set to be another solid year.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.