Spreads on triple-A tranches of new CLOs are likely to tighten by 10 to 15 basis points by the end of the year, according to Wells Fargo.

That would bring these spreads down to the range of 135 to 140 basis points over Libor, not nearly as low as the year-end levels some participants were forecasting at the beginning of this year. In a weekly research report, analyst David Preston said that a full pipeline of new deals and other factors such as a thin investors base will combine to limit downward pressure on CLO spreads.

“If primary supply is high, with a limited CLO AAA investor base, it is unlikely that AAA spreads can tighten appreciably,” he said.

Until recently banks were some of the biggest buyers of the senior tranches of collateralized loan obligations, but new deposit insurance rules have tempered this demand. As of April, the Federal Deposit Insurance Corp. assigns the same risk-weightings to all CLO tranches, regardless of credit rating. This gives banks an incentive to purchase riskier tranches instead of the triple-A.  

If banks aren’t buying as much, what will push CLO spreads lower?  Of the potential catalysts, Wells sees  increased relative value in CLOs as the primary possibility. “We believe that spread tightening, and yield compression in other assets would be the likely driver for triple-A tightening; that is, CMBS and ABS primary yields fall to levels that make CLO triple-As compelling, even when accounting for the FDIC charge,” Preston said.

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