European CLO mezz is undervalued, says Morgan Stanley

Single A and triple B European CLOs should generate double digit returns under most scenarios at today’s prices, calculates Morgan Stanley. In their CDO Market Insights report published last week, the bank’s structured credit researchers say that fundamentals only go part of the way to explain the difference between secondary prices of US and European CLOs.

The report notes that triple B tranches of European CLOs typically trade some 15 points lower than their US counterparts, which is a larger discount than justified under most assumptions about future losses. The bank looks at European CLO returns under three scenarios. Only under the most bearish scenario do triple Bs produce a negative return. In the other scenarios, the return is between 12.5% and 24.6%. For single A tranches, returns are positive under all scenarios.