Fitch: Basis Risk in European CLOs Limited by Low Interest Rates
Basis risk may arise between CLO notes that pay three months Euribor and the underlying leveraged loans that can switch to six months Euribor. In a rising interest rate scenario, the notes would reset faster than the underlying leveraged loans. In Fitch's analysis, which used data back to the early 80s for both US and European interest rates, the agency found that the negative basis is insignificant during a rise in interest rates. Fitch also analysed the switching behaviour of leveraged loans and found that less than half made use of the option to switch their payment frequency in times of interest rate changes, further limiting basis risk.
Fitch believes that its interest rate stress assumptions under the current low interest rate environment sufficiently address interest rate risk, including the risk of a negative basis between the indices on the notes and loans. Fitch will revisit basis risk once interest rates rise, increasing the risk of declining interest rates.
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