Investment grade European CLO tranches will not suffer losses, according to Fitch Ratings, which is true if the agency’s average default and base case recovery assumptions occur.

This statement follows today’s stress test results release in which five default stress scenarios were applied to European CLO portfolios.

The five scenarios saw cumulative defaults of 9.1%, 18.2%, and 25% (all over three years), and 50% and 65% over five years. They were set against three recovery scenarios: base case scenario, the current weighted average recovery rate (WARR); medium recovery rate scenario, 30% relative haircut to the WARR; and severe recovery rate, 50% relative haircut to the WARR.

Fitch's average default expectations fall between scenarios two (18.2%) and three (25%). Scenario three sees no losses at CLO tranches rated 'BBB' or higher. However if the medium recovery scenario is applied to scenario three, two thirds of 'BBB' rated tranches would experience losses. No losses would be evident in higher rating categories.

Under the base recovery assumptions devised by Fitch, all rated tranches can withstand the default of the average CLO exposure to assets rated ‘CCC’ and below. This includes assets rated ‘B-’ on rating watch negative.

"'AA' and above rated tranches start to exhibit losses under scenarios where defaults are assumed to exceed cumulative historical 10-year default peaks combined with medium or severe recovery rate stresses," said Jan Bockelmann, associate director in Fitch's structured credit team. "This analysis highlights that CLOs are highly sensitive to recovery rate assumptions. However, there is no reason why individual transactions should not outperform the market or suffer less defaults than their peers."

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