The first week of March 2025 will be remembered as a pivotal and seismic period for market participants, macro funds, and investors worldwide. A few key market reactions to recent macroeconomic data and global events include: the EUR/USD cross surged by over 4%, reaching levels not seen since November, while European yield curves across the board experienced a notable upward shift. The Bund 10Y yield spiked from 2.35% to 2.85%, and the future contract on the German bund lost six full figures over just five trading sessions. Until the end of February, many research houses considered the Bund to be undervalued or cheap and advised extending duration or receiving fixed. I did not share this view in my discussions with investors since the beginning of the year. Taking outright long duration trade positions seemed to me extremely risky and against fundamentals. The recent moves have been much more pronounced than the market reactions to the European Central Bank's (ECB) historic 75-basis-point rate hike in September 2022, the first of its kind. At the time, the ECB referred to the hike- a surprise for its size- as “a major step that front-loads the transition from an accommodative policy towards levels that will ensure the timely return of inflation to the ECB’s 2% medium-term target” (ECB statement). Yet, according to the ECB's latest press release on March 6, 2025, inflation is not expected to return to the 2% target until 2026. I will not comment the latest ECB decision, the sixth cut since June 2024, because we have been left with the usual words: no precommitment, data dependence, meeting by meeting approach. The volatility was not caused by the ECB and its hawkish comments. Despite the sharp market shifts registered last week, the credit market has demonstrated remarkable resilience, which may seem surprising at first observation. Morningstar’s ELLI index has only marginally declined from its peak of 98.7, and while the bond market has softened slightly more than leveraged term loans, these changes pale in comparison to the extreme volatility witnessed in asset swap curves, government bond yields and forex. **What, then, accounts for this constructive tone and unexpected stability?** The points that could justify this incredible behavior have been briefly described and touched in my last post. The explanation for the credit behavior can be found in how CLO (Collateralized Loan Obligation) vehicles are influencing price formation and credit spreads within the broader credit market. This phenomenon is similar to the effect of central bank Quantitative Easing (QE) and other "unconventional" monetary policies, where the transfer of private sector risk to central bank balance sheets effectively reduces the perceived cost of that risk, thereby easing financial conditions and compressing risk premiums. **But how do CLOs function?** The mechanics of securitization are well understood: assets—such as loans and bonds—are pooled together and sold to investors, with claims on the resulting cash flows allocated according to varying levels of seniority. One of the primary advantages of “tranching” is the ability to create multiple classes of securities, each tailored to suit the risk/return preferences of different investors. The levels of credit support provided across these tranches lead to securities with varying seniority, while structural provisions such as triggers and thresholds add another layer of security. CLOs (and other Asset-Backed Securities, or ABS) are structured with clear and proportionate rules that not only provide resilience to the vehicles themselves but also support broader market stability. By continuing to provide capital and credit to the financial system, CLOs enable lending and investments across a wide array of industrial sectors. CLO investors, on their side, recognize that securitization is a reliable mechanism for investment diversification, capital allocation, and risk distribution. With their diversified portfolios and ongoing demand for paper in warehousing and existing pools, these vehicles act as a buffer against volatility, helping to ensure market resilience even in turbulent periods like the one we recently experienced. Importantly, CLO investors are aware that in securitizations, they assume less borrower-specific financing risk compared to corporate debt investors, who are directly exposed to the credit risk of individual borrowers. **However, how long can this cushion withstand increasing volatility? For how long will credit risk transfer continue to function effectively amid turbulence in other asset classes?** In my opinion, CLO investors should be aware that the relationship between the credit quality of the underlying assets and the credit quality of the tranched securities is not linear. Indeed, the fluctuations in the value of securitized tranches, particularly after certain triggers are activated, often exceed those of the underlying asset pool. Structures with leverage greater than 10X tend to amplify changes in the valuation of the underlying assets. Every investor knows how the tranches behaved in the rare moments of volatility over the last 7-8 years (I skip the GFC). I am confident- but not fully convinced and I speak with deep knowledge of the facts-that many investors, particularly in the investment-grade tranches, have learned from past experiences not to rely excessively on ratings. Mezzanine investors and equity participants should understand how to avoid mispriced and mismanaged risk exposure to deteriorated asset pools or underperforming CLO platforms. CLOs securities behave like beta investments until the structures are put under pressures by rating migrations, asset prices volatility and tests. Diving just one level deeper and looking at the portfolios it becomes apparent that dispersion has increased year over year (but not at the level of the European pricing where the differences in WACC across managers are in 25 bps range). **When the market for credit risk transfer to structured securitizations stops to work, we experiment the credit market collapse of summer 2022. Vehicles tightly managed or extreme volatility acting swiftly, can make CLOs no more economically viable because the equity is impaired by carry considerations or valuation perspectives.** It's more complex than simply stating that the tails in both the high-yield and leveraged loan markets are growing. The beta risk of the plain vanilla CLOs could become a jump to idiosyncratic risk. Pooling bonds and loans and tailoring financial solutions to suit the underlying assets is an extraordinary financial innovation —one that is often misunderstood by investors and overlooked by Regulators. CLOs are not anymore an immaterial asset class or a niche product like 20 years ago. Investors would do well to learn from the current market dynamics, as the events of the past week provide valuable insights into the functioning of structured finance. These experiences should sharpen their ability to make informed decisions and ask the right questions to portfolio managers when navigating the credit markets. This is a critical moment for investors to deepen their understanding of ABS vehicles and CLOs, and their role in the broader credit landscape.

A closer look at the first week of March