On Breakingviews: It may sound hairy for banks to buy senior tranches of the CLOs they arrange, but it makes sense. The bigger problem is that such measures might not be enough to keep the $1 trillion market chugging along next year, writes Unmack1
. It seems like a repeat of the 2008 mess, when banks got stuck with unsellable mortgage securities. But it’s less risky than it sounds. Top-rated CLO tranches typically only take a hit once overall losses on the underlying loans exceed. So, for example, 70% of the whole portfolio would have to default, with the creditors recovering just half of their money, before AAA tranches see a loss. And the significantly higher spreads in 2022 implies bankers are being compensated well for that risk.
But the banks can’t keep the show on the road alone. If credit investors like hedge funds worry about a looming recession, they’re likely to steer clear of the riskier CLO securities that take the first hit when private equity-backed firms fail. A slower economy may also lead to rating downgrades on loans and CLO bonds, causing investors to demand higher yields. And the rising cost of debt continues to drag on private equity dealmaking, limiting the supply of the underlying loans.
CLOs pool debt used for buyouts and fund it by issuing bonds of varying risk to credit investors. Rating agencies typically give the highest-ranking tranches an AAA grade. European CLO sales, including refinancings, totalled 31 billion euros in the year to November, according to JPMorgan analysts, which was 67% below the level in the same period of 2021.
Banks’ willingness to act as an investor in AAA tranches has helped a number of CLOs “get over the line”, Morgan Stanley analysts wrote in a note to clients.Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias.
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