Capital relief trade issuers and investors are weighing in on the virtues of a structuring technique dubbed 're-tranching'. The innovation involves slicing in two the junior risk, in an attempt to cope with higher capital requirements under the CRR (SCI 23 February 2017).

"We're actively working with issuers and investors to move this forward," says Kaelyn Abrell, partner and portfolio manager at ArrowMark Partners.

The rise in senior risk weights is expected to force issuing banks to mitigate the capital increase by structuring transactions with thicker junior tranches. This is because the more credit risk a bank transfers lower down the capital structure, the better the rating for the senior tranche and hence the lower the associated risk weight.

However, if an issuer is forced to sell thicker tranches to achieve significant risk transfer, such a sale will not be economic for the bank if investors do not agree to accept the correspondingly lower return that comes with these thicker tranches (the latter being less risky). This is where the value of splitting or re-tranching the junior risk into first- and second-loss pieces enters the picture.

For example, under the new CRR and commensurate risk transfer rules, a bank may determine it is necessary to sell a position with a zero attachment point and a 12% detachment point in order to demonstrate significant risk transfer, which is greater than the 0%-8% tranche thickness that the bank would need to sell to meet the same tests under the current CRR. It is likely easier and less costly to divide such a position into two tranches - a first- and a second-loss position - because the bank would then be in a position to sell to different investors with different risk/return requirements. The first-loss investor, for instance, may need a 12% IRR, while the second-loss investor will have a lower return hurdle.

The re-tranching would then follow with a rating for the second loss before it is eventually sold to CLO-type investors. Besides allowing for easier financing, the existence of a rating means that an investor can be reassured that the credit outlook has been confirmed. Furthermore, ratings offer much-prized comparability.

Robert Bradbury, md at StormHarbour, notes: "It may help some investors to compare the tranche's risk-return profile with that of other securities, which feature similar underlying assets and granularity - though other prospective investors may not necessarily require external ratings."

An alternative to re-tranching could be simply to use leverage in order to raise the returns on the thicker tranches. Abrell believes that a combination of leverage and re-tranching will be used; however, additional tranching adds permanent, non-mark to market structural leverage that has some additional benefits over financing or traditional leverage.

Non-MTM financing would effectively amount to no margin calls. An inability to meet a potential margin call is the only way for an investor to lose their financed SRT. It is a tail risk and therefore unlikely to occur, yet certain investors do not use financing for this reason.

Supply is another issue. "There are a limited number of leverage providers on this asset class at the moment, and some funds are simply not able to use leverage," says Bradbury.

Following a rating for the second-loss piece, it is expected that investors such as hedge funds and insurance firms would target the single-B and double-B slice. "A number of investors have already expressed interest in the securities during preliminary conversations," observes Abrell.

She continues: "The single-B and double-B tranches can provide the risk/reward profile they prefer; however, the securities will offer less liquidity than CLO mezzanine securities. As a result, expected returns will need to reflect an illiquidity premium, in addition to the better underlying collateral that distinguishes SRT from CLOs."

Arrowmark itself is a CLO issuer, having printed 10 CLOs totalling US$3.6bn.

However, creating a market for the second-loss piece comes with its own set of challenges, such as the rating of the second-loss piece. For instance, in the case of less granular portfolios, there is a need for mapping between banks and rating agencies.

The latter is a rating exercise conducted by the rating agencies and it involves cross-referencing company names against names that have already been rated. The specific difficulty here is attributing a rating to a credit name when there is no data.

Market participants though remain relatively unfazed by these issues. "A number of deals, across several rating agencies, have already received ratings in various parts of the capital structure - so while it may pose challenges for some issuers, it is achievable with the right access to information," states Bradbury.

He adds: "The rating is not needed per se, but it helps with comparability and could potentially help with access to some types of investor."

Similarly, Abrell notes: "It's easier to assign a rating to a new second-loss tranche, if the senior tranche is already rated."

Nevertheless, re-tranching as an option is still at an exploratory stage, so actual transactions have not yet occurred. Some sources point to a six-month disruption period where the tranche will have to be sold at a higher spread, while others believe that the industry remains "a long way" from seeing these types of deals. Yet it is clear that as capital requirements bite and prospects for leverage appear subdued, re-tranching begins to look more tempting and hence more promising.

SP