The latest generation of European CLOs may expose investors to a risk that didn’t exist in most collateralized loan obligations issued before the financial crisis: fluctuations in foreign exchange rates.
A scarcity of euro-denominated loans has forced managers of new European CLOs to look at other kinds of collateral, including loans denominated in sterling. And in some cases, managers may not be hedging against changes in the exchange rate between sterling and the euro, Fitch Ratings warned in a May 20 report.
CLO managers are looking at sterling-denominated loans because it is difficult to find enough euro-denominated loans to fill their portfolio or assemble a portfolio of loans that is sufficiently diverse in terms of geography or industry. Managers are also under pressure to assembly their portfolio of collateral quickly in order to attract investors to deals at competitive prices.
CLOs issued pre-crisis also had sterling-denominated assets, but Fitch said they generally hedged the resulting foreign exchange risk in a number of ways: perfect asset swaps, macro hedges, out-of-the-money foreign exchange options and variable funding notes. Today, however, banks are less inclined to act as counterparties in such transactions, at least at a price that would be attractive to a CLO manager.
Fitch said the high cost of such hedges today “may have a detrimental impact on the economics of a new CLO and may already be affecting the pricing of sterling assets in a market where most legacy CLOs are required to buy euro assets or hedge non-euro assets on purchase.”
CLOs may therefore look to “match fund,” or issue a tranche of sterling-denominated notes that will be paid using interest payment from the sterling assets; or to “go naked” (unhedged) with their sterling exposures, Fitch said.
Match funding, while less risky than going naked, has some drawbacks. “There are a number of factors that can reduce the effectiveness of the hedge over time, such as defaults being skewed to sterling assets, a divergence of interest rates and maturity mismatches between sterling assets and sterling liabilities,” the agency said.