Are CLO investors underestimating tail risk in European markets?

Collateralised loan obligations (CLOs) are among the largest holders of leveraged loans. CLOs are tranched securitisations, meaning that they invest in risky pools of leveraged loans using funds raised by issuing notes, or tranches, with different risk profiles. The most senior notes typically have AAA ratings because they are insulated by the junior tranches from all but the largest losses, which are more likely when defaults are highly correlated. CLOs are popular with ultimate investors for three main reasons. First, investors can fine-tune the desired risk exposure to a large market, as leveraged loans amount to more than $1.5 trillion overall in the United States and Europe (Graph B, left-hand panel). Second, CLOs' floating rates are appealing for investors seeking hedges against rising interest rates. Third, CLOs tend to engage in search for yield, enhancing the income stream.

This box explores the potential implications of the energy crisis in Europe for AAA-rated CLO tranches, which are very sensitive to broad-based disruptions. Persistent issues with the supply of electricity or industrial inputs in Europe might worsen the outlook for many firms simultaneously, thus raising the risk of correlated defaults. Such a scenario could generate principal losses for AAA tranche investors, chiefly banks and insurers.  Even in the absence of outright credit losses, price declines due to increased risk premia could generate mark-to-market losses.

European CLO markets could be particularly exposed to correlated defaults. First, partly due to the smaller size of the European leveraged loan market relative to the US one, European CLOs have less diversified portfolios. Second, there is a higher overlap across the portfolio holdings of various European CLOs, which further limits investors' ability to diversify. Lastly, the European CLO market is relatively illiquid, which could amplify price swings in times of stress.

Given the geopolitical forces at play and the structure of European CLO markets, it is noteworthy that market prices are sending divergent signals about default correlations. On the one hand, investors in equity markets have recognised that, due to the fallout of the Ukraine war, the outlooks for European companies are more intertwined than in the past. Indeed, realised correlations among stock returns rose sharply in Q1 2022 and remained somewhat elevated relative to the previous year. On the other hand, investors in European credit markets appear to see only a limited increase in default risk co-movement. This assessment rests on two observations. The first is that the correlations of changes in credit default swap (CDS) spreads increased only slightly after the Ukraine war and dipped below Q1 2021 levels by mid-year (Graph B, centre panel). The second is that a common market-based proxy for future default risk correlation rose after the war's outbreak but subsequently eased back to early 2022 levels (right-hand panel).

On balance, the jury is still out on whether defaults will be more correlated in the future. It is not unusual that equity and credit markets send divergent signals about correlations, which may reflect investor segmentation.  However, if equity markets turn out to be correct in their assessment, the risk in AAA-rated CLO tranches is currently underpriced.

  The views expressed are those of the authors and do not necessarily reflect the views of the BIS.      S Aramonte, S Lee and V Stebunovs, "Risk taking and low long-term interest rates: evidence from the US syndicated term loan market", Journal of Banking & Finance, vol 138, May 2022.      For a detailed discussion of possible spillovers from the CLO market, see S Aramonte and F Avalos, "Structured finance then and now: a comparison of CDOs and CLOs", BIS Quarterly Review, September 2019, pp 11–14.      M Wang and L Wang, "Global CLO market mid-year outlook", Citi Research, July 2022.      H Zhu and N Tarashev, "The pricing of portfolio credit risk", BIS Working Papers, no 214, September 2006.