Hedge fund manager trips up as asset downgrades hit CLO
Hedge fund King Street Capital Management has fallen foul of the slew of asset downgrades hitting CLO portfolios amid the coronavirus outbreak.
The firm, which issues CLOs through its Rockwood Capital portfolio manager division, failed a portfolio test on its second European CLO at a key date in the transaction’s cycle, known as the effective date. In doing so, it is the first European CLO rated by Moody’s Investors Service to fail to meet all the portfolio requirements at this milestone.
Rockwood’s weighted average rating test, or WARF, which measures the credit quality of a portfolio, was worse than previously modelled, according to George Zittis, a vice president and senior credit officer at Moody’s. But, he added, there was no ratings impact as the structural features of the transaction and the characteristics of the portfolio, including other tests, compensated for the failure.
King Street is far from alone in tripping its ratings test: over 90% of European managers have done so, according to Bank of America analysts in a June 15 research note.
But the manager could have avoided this as the transaction was complying with its WARF test in March. If King Street had brought forward the effective date – as many others did amid the pick-up in the pace of downgrades on the underlying loan and high-yield bond assets – there would have been no issue. It was a “timing issue” according to Zittis.
In terms of next steps, King Street has agreed a trading plan with Moody’s to improve the credit quality of the portfolio and decrease the level of non-compliance of the WARF Test.
That could become challenging depending on market conditions and whether there are more assets downgrades. In addition, managers failing their WARF tests are restricted in what they can buy as any new asset has to either maintain or improve the credit portfolio.
In terms of portfolio stress, the manager’s two European CLOs hold up well against the rest of the European cohort. Based on data from Wells Fargo Securities research on June 24, its vehicles have the greatest over collateralization test cushion; 533 basis points compared with the median minimum cushion of 369 basis points.
The manager’s WARF score, at 3,267 sits below the median of 3,323, and its percentage of Caa-rated assets at 3.43%, compares with the median of 4.87%.
The transaction is currently on stable outlook by Fitch Ratings, which also rated the deal, and no ratings have been downgraded since its closing, according to a spokesperson for the firm.
King Street, a $18 plus billion global investment management firm, priced its first European CLO in 2018, and followed that it with this second transaction last year.
Its U.S. and European CLOs are issued via portfolio manager Rockford Tower Capital Management, while King Street Capital Management is responsible for staff & services.