A shift in the leveraged loan market has intensified grumbling among CLO managers about the way Standard & Poor’s rates the senior tranches of these deals.
When S&P overhauled its rating methodology for collateralized loan obligations in 2009, it incorporated updated recovery ratings assumptions on loans in the collateral pool when calculating the cash available to pay interest and principal to senior noteholders. Recovery ratings indicate the amount S&P expects loan investors to receive if the issuer defaults.
The difficulty in this approach has to do with “covenant-lite” loans, which the rating agency said usually have weaker recovery ratings and as a result, get less recovery credit.
In an April 5 report, S&P spoke about the dangers of rising issuance of covenant-lite loans. It said that its methodology actually captures the risk by using the same obligation-specific recovery ratings for both covenant-lite and full covenant loans, which of course puts covenant-lite loans at a greater disadavantage, and makes it harder for CLO managers to achieve triple-A ratings for portfolios with these types of loans. The rating agency declined to comment for this story.
Covenant-lite is a type of loan where funding is given with limited restrictions on the borrower’s debt-service capabilities, including collateral, payment terms, and level of income.
Strong demand for loans from CLOs themselves, as well as other investors, has made it easier for companies to borrower money without such restrictions. Covenant-lite loans accounted for as much as 60% of total leveraged loan issuance in January of this year, althought that percentage has since fallen, to as low as 30% in June, according to Thomson Reuters LPC.
David Preston, a CLO analyst at Wells Fargo, flagged the issue in a June 27 report that discussed the impact of the test on CLO managers’ selection of assets.
“CLO managers bring up the issue of recovery ratings a lot and there has been increasing talk of the market going to a Moody’s-only rating and not using S&P,” Preston said in an interview.
In the report, Preston wrote, “while the CLO market does not appear to be bumping against covenant-lite limits, covenant-lite loans might be a limiting factor in a more indirect fashion,” through the S&P recovery test.
Two recent CLOs carried a Moody’s-only rating. One was the Ares Enhanced Loan Investment deal worth $542 million that was due to close on July 31. It is managed by an affiliate of private equity firm Ares Management.
The other is Telos Asset Management’s Telos 2013-4 CLO worth $363 million, which was due to close on July 27, according to Asset Securitization Report’s ASR Scorecards database.
Part of the problem is that CLO managers don’t necessarily agree with S&P’s recovery ratings for loans. The ratings range between “1” and “6,” with a “1” rating indicating the highest level expected for recoveries in a default scenario. For example, a recovery rating of “2” indicates that S&P expects investors would receive 65% of their principal investment in the event of a default; and a rating of “3” indicates an expected recovery rate of 30%.
When CLO managers acquire loans or other assets that aren’t rated by S&P, the agency assigns a value that is based on the type of asset.
Preston says actual recoveries have proven to be much higher: Between 2007 to 2012, recoveries on assets with a “3” rating averaged 75%, more than twice the 30% figure implied by that rating.
“S&P essentially designed the stresses to hit the triple-A harder, with higher defaults and lower recoveries, and they stress the recoveries differently to reach the desired ratings on a triple-A CLO,” Preston said.
In his report, the analyst acknowledged that this methodology may be appealing to CLO investors, since the conservative projections for loan recovery rates give senior note buyers more confidence that their bonds will continue to perform well during periods of extreme stress. The downside, according to Preston, is that CLO managers might start selecting loans to use as collateral based on S&P’s rating methodology, rather than their own view of the credits.
Some CLO managers agree.
“Generally, S&P rated CLOs will be 5 points lower for the triple-A level weighted average recovery rate compared to Moody’s,” said Scott D’Orsi, a partner at Feingold O’Keeffe Capital who manages the firm’s CLO business. “It has become more of a difficult hurdle. From an asset recovery standpoint, what makes it a bit difficult is that sometimes it’s hard to understand why a loan is assigned a recovery of “3,” let’s say, instead of a “1” or “2.” Managers are forced to incorporate recovery ratings that might be inconsistent with their own credit analysis.”
Managers often decide to seek a rating from a second agency because CLO investors, particularly senior note holders, demand it. Market participants say that Asian and European investors, traditionally big buyers of the triple-A tranches of CLOs, are particularly interested in having both a Moody’s and S&P rating on deals. Although these kinds of buyers have been less active in the market of late, there’s a reluctance on the part of some CLO managers to use a single rating agency and risk reducing demand for the senior tranche in the secondary market.
“Whether a deal will be rated solely by S&P or solely by Moody’s, or perhaps both, can depend on the sensivity of the senior notes investor group,” D’Orsi said. “There may be triple-A buyers that do not require two ratings, which in turn can have an impact on the collateral that is purchased. These nuances take place on a deal by deal basis and can vary depending on how the senior notes are sold.”
He said that, ultimately, the market might be geared toward either having Moody’s-rated or S&P-rated deals. “Some collateral managers as well as CLO investors may migrate towards one agency over the other. Moody’s analysis tends to be more sensitive to corporate credit ratings while S&P’s incorporates recovery ratings a bit more. In the 2.0 world, investors know what they are looking for both in a deal and in a manager, and the experienced manager can navigate these structural considerations.”
“We are an outlier in this issue. Although we have noticed that S&P has become a little more conservative in terms of its recovery rate assumptions when it comes to the prevalence of covenant-lite primary issuance, we haven’t found it to be much of an issue since we have been passing our recovery rate cusps,” said one CLO manager who declined to be quoted by name.
“Maybe it has something to do with our credit process as we have gravitated to loans that have exhibited better recovery characteristics.”
Other participants say they are resigned to S&P’s use of loan recovery ratings, but would want more clarity about the way they are applied to CLO cash flow analysis.