Amid growing concerns about leveraged loans and collateralized loan obligations (CLOs), European regulators find that the fund industry’s exposure is limited, but investor risks are still present.
The European Securities and Markets Authority (ESMA) said that policymakers are increasingly concerned about risks stemming from a “significant pickup” in the issuance of leveraged loans and CLOs in both the U.S. and Europe.
To assess the threat, the ESMA examined the exposure of investment funds to these assets in its first study that combines industry data with regulatory data to provide a comprehensive market view.
Overall, it concluded that the fund industry’s exposure remains limited, but that the assets themselves may pose a threat to certain investors.
“The deterioration of underwriting standards coupled with low spreads point to a potential underpricing of risk,” the ESMA said.
Additionally, it reported that average credit ratings for leveraged loans “have recently deteriorated, and simulations carried out by ESMA show that model uncertainty can impact the credit ratings of CLOs, potentially triggering forced sales from some types of investors.”
Looking ahead, the ESMA said that it will be reviewing the quality of the rating processes for CLOs to assess their robustness.