The securitisation spread charge in the standard formula, worked on a CLO tranche, set against a corporate bond of the same rating and against the loans inside the CLO.
Under the Solvency II standard formula a CLO tranche is a securitisation position that is not STS, so its spread stress is its duration multiplied by a factor set by credit quality: 12.5 per cent a year at AAA, rising to 100 per cent for lower ratings. An illustrative 150.0m AAA tranche with a 4.0-year duration costs 50.0 per cent, 75.0m of capital, against 3.6 per cent for an AAA corporate bond of the same duration and 30.0 per cent for the B-rated loans the CLO holds.
Worked in full in Insurance Capital for Asset Managers by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A credit manager pitching a CLO tranche or a CLO fund to a European insurer will be judged on return per unit of capital, not on spread. The spread charge on ordinary bonds and loans, worked in how to calculate the Solvency II spread risk charge, is moderate for investment grade. Securitisations have their own article in the Delegated Regulation, Article 178, and their own, much heavier factors. Most CLO conversations with insurers that end early end on this calculation.
| Input | Value |
|---|---|
| Allocation | 150.0 |
| Spread duration of each position | 4.0 |
| AAA CLO tranche discount margin | 1.30% |
| AAA corporate bond spread | 0.50% |
| B-rated leveraged loan margin | 3.50% |
Spreads are illustrative, not market levels. The duration of 4.0 stands for a tranche with an expected life of about five years; for a floating-rate note the regulation uses the modified duration of an equivalent fixed-rate bond of the same maturity, not the time to the next coupon reset, so the charge is not cut by the quarterly reset.
| Credit quality | Non-STS securitisation | Bonds and loans |
|---|---|---|
| AAA | 12.5% | 0.9% |
| AA | 13.4% | 1.1% |
| A | 16.6% | 1.4% |
| BBB | 19.7% | 2.5% |
| BB | 82.0% | 4.5% |
| B | 100.0% | 7.5% |
The securitisation factors are those of Article 178 for positions that are neither STS nor resecuritisations, as amended in 2018; the bond factors are the first band of Article 176. The calibration has been under review at EU level, so confirm the text in force at the reporting date.
Spread stress = min(b × duration, 100%)
Capital = stress × market value
Return on capital = spread ÷ stress
In Excel: =MIN(B2*B3,1)*B1 with value in B1, factor in B2, duration in B3.
Step 1, classify the position. STS status requires, among other things, that the portfolio is not actively managed on a discretionary basis. A managed CLO fails that test, so it is an other securitisation. Seniority does not rescue it: a senior STS position gets factors close to those of corporate bonds, but the AAA tranche of a CLO is charged on the non-STS row.
Step 2, apply the factor. AAA is credit quality step 0: 12.5% × 4.0 = 50.0 per cent. On 150.0m that is 75.0m.
Step 3, compare. An AAA corporate bond of the same duration: 0.9% × 4.0 = 3.6 per cent, 5.4m. The B-rated loans inside the CLO, if held directly: 7.5% × 4.0 = 30.0 per cent, 45.0m.
| Position | Stress | Capital | Spread income | Spread on capital |
|---|---|---|---|---|
| AAA corporate bond | 3.6% | 5.4 | 0.75 | 13.89% |
| B-rated loans, held directly | 30.0% | 45.0 | 5.25 | 11.67% |
| AAA CLO tranche | 50.0% | 75.0 | 1.95 | 2.60% |
The tranche costs 13.9 times the capital of an AAA bond, and 30.0m more than the loans it is built from, although it sits above the junior tranches that absorb the first losses. Its spread on capital, 2.60 per cent, is a fraction of the alternatives. To match the bond's 13.89 per cent, the tranche would need a margin of 6.94 per cent, 694 basis points: no AAA paper pays that. For how an insurer ranks those figures across a mandate, see return on Solvency II capital for a fund.
| Rating | CLO tranche | Capital | Corporate bond | Capital | Multiple |
|---|---|---|---|---|---|
| AAA | 50.0% | 75.0 | 3.6% | 5.4 | 13.9 |
| AA | 53.6% | 80.4 | 4.4% | 6.6 | 12.2 |
| A | 66.4% | 99.6 | 5.6% | 8.4 | 11.9 |
| BBB | 78.8% | 118.2 | 10.0% | 15.0 | 7.9 |
| BB | 100.0% | 150.0 | 18.0% | 27.0 | 5.6 |
A BB tranche hits the 100 per cent cap at a duration of just 1.22 years: the insurer must hold its full value in capital. Duration is the other lever. At AAA, 2.0 years costs 25.0 per cent and 5.0 years 62.5 per cent, so a manager can do more for an insurer by offering shorter paper than by offering higher ratings.
Quoting the corporate bond grid for CLO paper because the tranche is AAA, or presenting a CLO fund to an insurer with the look-through data mapped to ordinary bond factors. The insurer's own calculation will put the positions on the securitisation row, and a fund pitched at a few per cent of capital arrives at 50.0 per cent. The reverse also happens: a manager of a loan fund assumes its loans cost as much as a CLO, when held directly at 30.0 per cent they cost less than the AAA tranche.
For an insurer that cannot look through the fund at all, the whole holding falls to the 49 per cent type 2 equity charge, before any symmetric adjustment, which at a 4.0-year duration is close to the AAA tranche itself.
The full Article 176 grid that the bond comparison reads, and the ranking of candidate funds on return on capital, are in the free workbooks for the book.
In general no: the EU STS criteria exclude portfolios actively managed on a discretionary basis, which describes a typical CLO. The tranche is therefore charged as an other, non-STS securitisation, 12.5 per cent per year of duration at AAA, so 50.0 per cent at a 4.0-year duration, regardless of how senior it is.
Because the securitisation factors were calibrated separately and conservatively. Held directly at a 4.0-year duration, B-rated loans are charged 7.5 per cent a year, 30.0 per cent in all; the AAA tranche protected by the junior tranches is charged 50.0 per cent. On 150.0m that is 30.0m more capital for the safer position.
Divide the corporate bond's spread by its charge and multiply by the tranche's charge. A 0.50 per cent spread on a 3.6 per cent charge earns 13.89 per cent of capital; at a 50.0 per cent charge the tranche would need 6.94 per cent, about 694 basis points, far above any AAA spread. That is why European insurers hold little CLO paper under the standard formula.
This article is one calculation from Insurance Capital for Asset Managers. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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