By Cezary Podkul and Megumi Fujikawa | Photography by Ben Weller for The Wall Street Journal 

Shogo Takemoto's family has tilled the rice fields of eastern Japan for more than 200 years. They stash their savings in an agricultural cooperative and borrow from it to help finance the farm's day-to-day operations.

But with interest rates near zero, the return on the loans is too little to keep the cooperative going. So it deposits Mr. Takemoto's savings with Japan's bank for farmers and fishermen, which sends the money overseas to earn a better yield.

That's how Mr. Takemoto became an indirect investor in car rental company Hertz Global Holdings Inc. before it declared bankruptcy in May. Among the owners of Hertz's debt was Norinchukin Bank, which owned bonds backed by pieces of loans to struggling companies like Hertz.

Later that month, the bank--founded nearly 100 years ago to serve the people who feed Japan--disclosed a staggering $3.7 billion unrealized loss on such bonds and said it would pause further investments.

The loss, which has mostly been recouped as markets rebounded, was shocking for its size and also because Norinchukin invested exclusively in triple-A rated bonds, which are supposed to be among the safest securities anywhere.

The stumble disrupted one of Wall Street's most lucrative trade routes--a steady flow of capital from yield-starved investors in Asia who turned to the U.S. to avoid the sting of zero interest rates at home. In doing so, they channeled their customers' savings into a boom for loans to some of America's riskiest corporate borrowers.

"One of the ironies of the global financial system is that a conservative institution managing the savings of Japanese fishermen and farmers ends up financing an increase in leverage among risky U.S. companies," said Brad Setser, a senior fellow at the Council on Foreign Relations who tracks global capital flows.

Norinchukin invested in collateralized loan obligations, or CLOs. These debt funds are meant to give investors access to higher yields with little additional risk because they buy slices of hundreds of different corporate loans. Known as leveraged loans, these corporate loans finance risky borrowers. Because they are unlikely to all struggle at once, credit-rating firms have labeled most CLO debt triple-A, putting its risk on par with the U.S. government.

Norinchukin's CLO holdings, all rated triple-A, account for about 12% of its overall portfolio, financial filings show. The bank said that it has been more selective in its CLO investments in recent months. "Our [CLO] holdings have declined since last year as we carefully select our investment based on market conditions," Norinchukin said in a statement.

Those holdings may no longer be as safe as their triple-A ratings would indicate. This spring, government-mandated shutdowns forced businesses of all kinds to suddenly shutter, eroding some of the benefits of diversification that underpin CLO ratings. One recent analysis of 95 triple-A rated CLO bonds found that all of them lost their pristine grades once their rating model was updated to reflect higher correlations of defaults among businesses.

"A triple-A CLO makes no sense in this market environment," said Rod Dubitsky, a former Moody's Corp. analyst who conducted the analysis using Moody's-rated CLOs. An academic study published in October also concluded CLOs appear riskier than their ratings suggest.

A Moody's spokesman said its triple-A rated CLOs "continue to perform well despite the unprecedented economic fallout caused by the global pandemic."

The market for leveraged loans has doubled since 2008 to about $1.2 trillion, according to LCD, S&P Global Market Intelligence's loan research arm. The U.S. market for CLOs grew in lockstep, reaching nearly $700 billion by March, when the coronavirus pandemic squeezed deal flow.

Most of that growth came via the Cayman Islands, where zero tax rates have long attracted money managers seeking a way to give their clients easy access to U.S. investments without additional tax burdens beyond their home countries. So many CLOs have been set up in the Caymans that the offshore financial center has become the world's biggest foreign lender to U.S. corporations, accounting for around $6 out of every $10 lent to U.S. businesses from abroad, according to capital flows data analyzed by The Wall Street Journal.

Foreign investors helped fuel the growth: They supplied about 20% of the capital behind U.S. CLOs, with Norinchukin alone accounting for around $4 out every $10 of foreign inflows, the Journal estimates. Today, the bank holds about $72 billion of CLO debt, or roughly 10% of the market. About three-fourths of those holdings were accumulated since December 2015, when the Federal Reserve began raising rates in the U.S. Shortly after, yields on Japan's 10-year government bond turned negative for the first time ever.

The widening gap between interest rates in the U.S. and Japan left Japanese lenders in a tough spot. They could either invest locally and earn next to nothing, or go hunting abroad for yield. Many chose the latter option, but few had a bigger need to do so than Norinchukin.

The nearly 100 year-old lender was set up to serve Japan's agricultural, fishing and forestry industries. It does so by essentially acting as a bankers' bank for a system of cooperatives set up after World War II to serve each of those industries. Over the years, they have expanded to operate hospitals, banks and insurance brokerages even as Japan's agricultural output shrank and hundreds of thousands of Japanese left farming.

To support that vast infrastructure, Norinchukin collects money from its member cooperatives, makes investments and pays back interest to them in the form of so-called incentive payments. The interest rate, 0.55%, became impossible to earn once Japanese interest rates fell below zero in 2016, so Norinchukin sought yield overseas.

"The need to secure sources of incentive payments has always been the underlying thinking" of Norinchukin's investments, said Aki Aneha, a Komazawa University economics professor who has studied Japan's agricultural history.

In 2018, as the gap between key U.S. and Japanese interest-rate benchmarks widened to nearly three percentage points, Norinchukin vastly expanded its CLO investments. The bank added a net $27 billion to its holdings, financial filings show. It also increased the number of CLO managers that it works with, industry sources say.

Norinchukin's heft made it a coveted investor in the CLO industry. The bank frequently bought entire triple-A pieces of CLO deals, according to people in the industry familiar with its operations. That gave Norinchukin the ability to insist on its own deal terms, known in the industry as Nochu stipulations.

Today Norinchukin works with a who's who of the CLO industry. Its stable of CLO managers includes such firms as Apollo Global Management, Ares Management Corp., Neuberger Berman Group, Eaton Vance Corp., Blackstone Group's GSO credit investment arm and First Eagle Alternative Credit, among more than a dozen others.

Michael Herzig, head of business development for New York-based First Eagle, says it's not easy landing a spot on Norinchukin's list of approved managers. The bank monitors managers' performance and handpicks whom it wants to invest with. "It's like getting an offer from Goldman Sachs. The more you ask, the less likely you are to get it," Mr. Herzig said.

The coronavirus pandemic hit the CLO market quickly. In a matter of days in March, prices of hundreds of loans owned by CLOs plummeted as business closures took a toll on the economy.

Some CLOs went shopping for bargains. First Eagle, which runs a suite of CLOs known as Wind River, scooped up about $10 million worth of a loan issued by Hertz just days before the car rental company filed for bankruptcy in May, trading disclosures show. The Wind River funds paid around 66 cents on the dollar for the investment.

Five months later, Hertz has obtained financing to carry itself through bankruptcy and its once-discounted loan is trading nearly at full face value, benefiting end-investors like Norinchukin, which owns pieces of the Hertz loan via several of First Eagle's CLOs.

Such buying-and-selling of loans--and the Federal Reserve's unprecedented support for corporate credit markets--made it easier for CLOs to weather the fallout created by the pandemic. Although thousands of businesses have filed for bankruptcy this year and vast swaths of loans have been downgraded, prices for investment-grade CLO bonds have mostly recovered, pricing data from Solve Advisors shows. Some asset managers have even launched exchange-traded funds that buy CLOs, with one claiming the ticker "AAA."

A Norinchukin spokesman said the bank held a Yen130 billion ($1.24 billion) unrealized loss on its CLO portfolio at the end of June, down from the $3.7 billion March-end figure it disclosed in May. At the time Norinchukin said it would pause making new investments as it re-evaluated its holdings. But it remains committed to staying in the market.

"There is no change in our view that we will continue to invest in CLOs as part of our credit assets," the bank said.

Mr. Takemoto, whose 50-hectare rice farm is in Japan's Ishikawa prefecture, said he didn't realize that his money traveled to Tokyo, the Cayman Islands, New York and on to Hertz. But he doesn't blame Norinchukin for sending his savings overseas.

"I think it is OK to make aggressive investments as part of a large portfolio," he said.

Write to Cezary Podkul at cezary.podkul@wsj.com and Megumi Fujikawa at megumi.fujikawa@wsj.com

(END) Dow Jones Newswires

November 05, 2020 05:44 ET (10:44 GMT)

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