Global credit funds & CLO's
October 2020 | Issue 228
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Opinion CLOs
Thomas Majewski
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CLO collateral managers who are able to update their documents could gain warf advantage
Founder & managing partner Eagle Point Credit Management
October 2020 | Issue 228
Last month, Moody’s published a request for comment (RFC), inviting market participants to share their views on a proposed revision to the methodology for calculating CLO weighted average rating factors (warf). The RFC considers adjusting the notching mechanics for loans where the obligors have been placed on negative watch or outlook.
As most CLO market participants know, Moody’s uses warf to infer the default probability of a portfolio. If warf rises above certain thresholds a CLO collateral manager’s flexibility to trade their loan portfolio is reduced.
Currently, when calculating warf, generally an obligor’s corporate family rating (CFR) is assigned a numeric factor, which increases exponentially as ratings decline. When assessing what CFR should apply to an obligor for warf purposes, Moody’s adjusts the rating down by two notches, or rating sub-categories, from when it is placed on review for downgrade. When on review for upgrade, it notches up by one sub-category. Under the proposed update, Moody’s would treat positive and negative watches equally, adjusting by a single notch for both.
Separately, Moody’s methodology also makes adjustments to an obligor rating based on assigned credit negative outlook, its opinion on the probable direction of a rating update in the medium term, such that a corporate obligor’s rating is notched down by one when it is assigned a negative outlook. Yet there is no up-one notching for borrowers on positive outlook. Under the proposal, adjustments would no longer be made based on ratings outlook.
Negative outlooks for nine months
If implemented, Moody’s proposed changes will improve portfolio warf in most, if not all CLOs it rates. In addition to Moody’s expectation of potential upgrades of some CLO tranches, the suggested changes may offer CLO collateral managers more trading flexibility.
Roughly 80% of Moody’s rated CLOs within their reinvestment period are failing their warf tests. With 5% of US CLO loan collateral under downgrade watch and nearly 20% more on negative outlook, the proposed methodology reduces the punitive impact from negative outlook and watch designations to nearly a quarter of CLO loans. The proposed changes will assist in curing many otherwise failing warf tests, and in certain CLOs, Caa concentration limit breaches.
Furthermore, this methodology update, if implemented, could cause an increase in the market value of some B3 loans on negative outlook, which may become more attractive to CLO portfolios since they are no longer subject to notching.
We expect proactive CLO collateral managers to use amendment provisions to conform to the latest rating agency criteria if the proposed methodology is ratified. With less pressure on their warf tests, especially if such warf tests are linked to constraints such as the covenant-lite concentration limitations, CLO collateral managers which are able to quickly update their documents will gain a competitive advantage and potentially further increase performance dispersion.
Considering Moody’s findings in its historical data review and the undue structural constraints currently exacerbated by the notching requirements, we believe the proposed methodology modification should be a positive change for the loan and CLO markets.
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Moody’s is reviewing its approach to warf. Changes could boost managers’ ability to trade
CLO upgrades and trading flexibility
In a review of its historical data, Moody’s discovered that obligors generally remain on negative outlook for an average of 278 days — a period far longer than the average 96 days a review for such a downgrade requires. Furthermore, these reviews concluded with a downgrade of the obligor’s rating less than half the time. Yet, during this roughly nine-month average watch period, many CLO portfolios will suffer significant warf test tightening while the market waits for resolution of the watch designation. Investors may have suffered as a result.
After S&P’s recalibration of its CLO criteria with more empirical data in 2019, Moody’s is now following suit. We believe this reflects the long-term resiliency of loans, as well as CLOs more broadly as an asset class.
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