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Reuters
Reuters
LONDON (Reuters Breakingviews) – Bankers in Europe have found a creative way to keep their buyout-debt machines ticking over: keep some of the risk themselves. It may sound hairy for lenders to buy senior tranches of the collateralised loan obligations (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.
CLOs effectively pool buyout loans and slice them up into securities with different layers of risk. Asset managers like Blackstone or Axa pick the underlying loans, while investment banks underwrite the CLO securities and place them with credit investors. Many of the bonds that come out the other side get an ultra-safe AAA credit rating. In 2021, global volumes exceeded $220 billion, making CLOs a key player in funding private-equity deals.
Yet rising interest rates are denting the appeal, since investors can now get relatively chunky yields elsewhere, like in government debt. To tempt investors to buy even the top-rated AAA CLO tranches in Europe, arrangers have had to increase the yield to over 200 basis points above risk-free rates, compared with an 80-basis-point spread at the start of 2022, according to one banker. Some buyers of senior bonds, like Japanese banks, have stepped back. The combination of higher funding costs and slower private-equity dealmaking has pushed sales of European CLO securities down 67% year-on-year, according to JPMorgan analysts.
Bankers are finding a way to keep things going. Société Générale, BNP Paribas and Deutsche Bank, for example, are investing their own money in senior tranches of CLO deals they arrange, Bloomberg reported. 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 35%. 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. That means banks’ biggest CLO risk is an even sharper slowdown, not a blowup.
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CONTEXT NEWS
BNP Paribas, Société Générale and Deutsche Bank are buying tranches of the collateralised loan obligations (CLOs) they arrange, Bloomberg reported on Dec. 5.
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.
(Editing by Liam Proud and Streisand Neto)
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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