As I mentioned last week, issues around establishing fair value for less liquid securities remain a focus for many in the financial data business. The marketplace has seen the emergence of highly specialised financial products over the past several years, and data practitioners are having to come to grips with how to deal with these products from a pricing standpoint.
In the second of our series of webinars covering valuations for high-yield corporate credit assets, we look at collateralised loan obligations (CLOs) and discuss how best they can be valued with Cynthia Sachs, global head of product development for Bloomberg’s valuations service (BVAL), and Jesse Knapp, managing director of Kanerai, a developer of analytic solutions for CLOs and other asset classes.
The webinar reviews changes in how CLOs are valued, regulatory demands around the asset class and price challenges, highlighting the need across valuations for transparency, multiple data sources and independent, third-party pricing provision.
Bloomberg partners with Kanerai to value CLOs for its BVAL service. These securities can be difficult to price, but are of increasingly major interest to clients in the corporate sector. Sachs explains: “CLOs are a pool of loans and bonds that are high yield by nature, but essentially a derivative. If a firm wants to diversify risk, CLOs are interesting as they offer a pool of diversified risk. You can take a view on corporate credit risk and manage it by taking different tranches from the pool.”
The pricing and valuation of CLOs has evolved over time. Knapp describes how buy-side clients would ask the dealers that sold them the securities for CLO prices on a monthly basis and would then negotiate valuations. Moving on, third-party pricing services were created, but they were often matrix-based and assumed that all similar securities, such as those with Triple-A ratings, traded in approximately the same spread. This did not take account of the fact that not all Triple-As are equal and that they have differing risks. Alternative services valued bonds on a one-off basis, looking at the price of a security in the previous month, adjusting it using a rough estimation and then negotiating.
While these methods satisfied pre-Credit Crisis needs, the post-crisis regulatory environment called for change. Knapp explains: “Clients need transparency, better pricing and third-party pricing. In an increasingly regulated environment, internal risk teams and auditors became less comfortable with having the dealer who sold securities providing a valuation for them. They were also uncomfortable with the matrix-based approach as it was difficult to justify why two bonds with different loan portfolios and risk should be priced the same because their ratings were the same. Before the crisis this could be done and would be right most of the time, but in today’s market it would be wrong and would misrepresent the value of a portfolio to shareholders.”
Focussing on regulation, Knapp says everything from fair value accounting to Solvency II and Basle III requires a methodical approach to pricing CLOs so that inputs and the framework of valuations can be understood and easily explained to regulators and auditors.
Sachs notes the case for transparent inputs and a methodical approach in price challenges. She says: “A client may question a price if it is not where it was expected to be. In situations like this, we need to be able to justify prices in our valuations service. Historically, this was an onerous process, so we streamlined it and work closely with Kanerai, which owns the valuations methodology and provides transparency.”
Kanerai’s methodology includes gathering market observations and market colour around trading to value tranches of CLOs. It uses hundreds of pieces of market data to inform pricing and can then show the inputs into valuations and how they were derived if there is a challenge. The company has market advantage in being an independent third-party in valuations and can provide a daily service to clients that want to monitor CLO price changes and avoid any surprises in month end portfolio reports.
Pulling together the capabilities of Bloomberg and Kanerai, Sachs concludes: “We have a full suite of high-yield corporate credit valuations services and expert employees who work in a similar way to Kanerai. We cover portfolios in an holistic way and provide transparency to help clients understand and own valuations, and be confident in discussions with regulators and auditors.”
You can listen to the valuations webinars presented by A-Team Group and sponsored by Bloomberg on the Reference Data Review website.
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We hope you enjoy the webinar series.