For CLO managers, watching the declining performance of their underlying collateral has been about as much fun as a Tijuana jail. And it doesn't look like they'll make bail anytime soon.
A number of issues are putting pressure on CLO mangers, the most burdensome of which, sources say, is deteriorating loan value. Deteriorating value is driving down ratings, and, adding fuel to this fire, the rating agencies have proposed changes to their CLO rating methodologies, which could push ratings down further. Meanwhile, the falling three-month Libor rate is also cutting into returns.
Over the past two months, 15 loan issuers have defaulted, roughly equal to the cumulative amount of loan defaults between 2002 and 2007. These defaults, and the downward pressure they have put on the loan market, caused the average triple-C basket size to balloon to close to 10%, much higher than where those baskets should be, a Citigroup Global Markets report said. Furthermore, the default rate for U.S. CLOs has increased by 0.6% to 2%, not including the months of December and January.
CLO managers are bound by their contracts to keep their buckets within certain parameters. If the size of one bucket gets too big, they have to take corrective measures to bring the CLO back into balance. One way to do this is to sell the lower-valued debt and buy higher-rated debt in hopes this will correct the shortfall. Another way is to sell assets and reduce the amount of senior debt outstanding, thus deleveraging the portfolio.
Presently, an increasing number of CLO managers are looking to upgrade their portfolio with higher-rated debt, and they are overloading their single-A buckets.
CLO managers could see even more downgrades if Moody's Investors Service and Standard & Poor's go through with proposed changes to their CDO and CLO rating methodology. Both rating agencies will assume increased levels of default probability for credits that are under "review for possible downgrade" or have a "negative outlook," according to Citi analysts. Moreover, both agencies have announced that their rating methodology will shift from long-term averages to something more predictive, added the Citi report. This will increase the expected cumulative loss, due to the assumption that default rates will reach historic highs in 2009 and 2010. This change could cause default rates to double and recovery rates to halve.
Calls to S&P and Moody's were not returned by press time.
These changes are not the only ones planned. Both agencies plan to change their assumptions about the way this additional risk should be distributed around the capital structure, with senior tranches being the most adversely affected, said Citi analysts.
When the changes go into affect, many CLO tranches could be downgraded from three to seven notches on average. This could force more unwinds, widening spreads and further diminishing investor confidence.
On top of all of this, falling three-month Libor rates are hitting CLO managers hard. The three-month Libor rate has fallen to 1.18% from around 3.5% this time last year.
"We should be indifferent and usually are as long as we are not squeezed by [Libor]. But the loans are only paying you or the CLO at 3%, but you pay the bonds-the triple-A rated part of the CLO-4.7%," said a CLO manager. "Also, in a high default environment, lower interest costs are good for companies. However, if you are violating an OC test and need excess interest to cure it, lower Libor can hurt you because the higher the Libor rate the more net interest you get."
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