FDIC Rule May Limit CLO Spread Narrowing, Morgan Stanley Says

A new rule governing high-risk loans may change how banks insured by the Federal Deposit Insurance Corp. invest in collateralized loan obligations as they assess the cost of holding assets calculated in their ability to withstand stress, according to Morgan Stanley.

The regulation requires CLOs, which buy and package speculative-grade credit into securities of varying risk and return, to be treated as “higher-risk” assets, Morgan Stanley said today in a report.

The designation may also include the least-risky portion of CLOs, rated AAA, under the FDIC regulation set to take effect on April 1 for U.S. banks with $10 billion of assets or more, the New York-based lender said. The rule may limit the narrowing of spreads in the top-rated portion of CLOs as banks consider investing in lower-rated slices of the loan funds, according to the note.

“There is a potential for some banks to rethink the extent of their continued participation in the CLO market,” Vishwanath Tirupattur and Mia Qian, analysts with Morgan Stanley, wrote in the report. “It is conceivable that some bank investors consider investing in AA tranches to offset the higher FDIC assessments.”

A total $17.8 billion of new CLOs have been raised this year, as issuance continues at a “robust pace” helped by tightening spreads, according to Morgan Stanley. The tightest AAA spread this month for the loan funds is 110 basis points more than the London interbank offered rate, the bank said. A basis point is 0.01 percentage point.

“It is unlikely that the reaction to CLO investments will be uniform,” the Morgan Stanley analysts wrote. “In our view, even after taking the potential higher assessment rates into account, CLO AAAs offer attractive relative value compared to other alternative investment opportunities for banks.

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