Basel III looks likely to further increase banks investment in CLO triple As

Thomas Majewski

Founder & managing partner Eagle Point Credit Management

As the banks’ costs rose, the yield on their fixed rate agency and treasury investments remained unaltered

Demand for CLO triple As has grown substantially over the past few years as more banking institutions, pension funds, asset managers and insurance companies discover this attractive asset class, which historically has never taken a loss. In the coming years, we expect this demand to increase further as both regulatory and economic tailwinds continue to support CLO triple As, especially among banks.

Exposure to CLO triple As is already broadly adopted across the banking system. Recently, a CLO research desk estimated that US banks make up approximately 20% of the overall CLO market, and roughly one-third of the CLO triple A market.

Several banks that report their holdings publicly often show CLO triple As as a top-three exposure — just behind US Treasury bonds and agency securities. With the Basel III ‘endgame’ proposal now available for market digestion, we expect bank participation of the CLO triple A market to increase further.

Standardising risk measurement

Basel III is an overhaul of the regulatory bank investment risk weighting for bank capital requirements that has been underway since the financial crisis in 2008. It is expected to be finalised in the next year and will have a substantial effect on both banking investment and underwriting practices. The current Basel III proposals primarily aim to standardise the way banks measure risk by including an overall more robust weighting framework that considers market, trading and operational risk in addition to credit risk.

The proposal requires banks to provide more robust disclosures of their risk weighted modelling outputs, and significantly increases market transparency on banking mark-to-market losses. It also significantly favours higher-attachment, triple A-rated securitisation exposures. For example, as currently drafted, agency mortgage-backed securities receive a risk weight of 20%, while triple A-rated structured credit has been reduced to require only a 15% risk weight.

This more favourable capital treatment is hard to ignore, especially considering the strength and resilience of CLO triple As, and their floating rate coupon. Even if we were to see revisions to bring these asset classes more in step in weighting (to assets at the 15% risk-weight), the overall move is notably positive for future CLO investment.

Some bank failures could be prevented

The new proposal extends regulation to all banks with over $100 billion in assets, picking up many small to mid-sized banks not previously covered. Despite the current strength of the US banking system, there were three major regional bank failures this year. In each case, interest rate risk was a critical factor. As the banks’ costs rose with rising rates, the yield on their fixed rate agency and treasury investments remained unaltered. If they had been holding more CLO paper, they might still be in business today.

Notably, the new Basel III rules may also require small banks to report losses in the available-for-sale books in their equity ratios. To avoid rate volatility, purchasing more stable floating rate products is preferred — and CLO triple As have had some of the lowest mark-to-market movements in banking portfolios in the last 12 months, according to the large CLO research desks, like Bank of America.

Away from regulatory preference, the high income spread today of CLO triple As should also continue to make them relatively attractive to all banks, especially against their current borrowing costs. In what may be a potentially ‘higher for longer’ environment, banks are incentivised to avoid asset liability mismatches to mitigate volatility as rates continue to move in the future.

Basel III is still subject to comment and may change in ways that lessen the disparity, but nevertheless, it seems likely that its treatment of CLO triple As, relative to many other securities, creates an incentive for additional bank investment in the CLO market.

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Global credit funds & CLO's

October 2023 | Issue 258

Published in London & New York.