Collateralized loan obligation spread tightening has been so dramatic, particularly in subordinate tranches, that an increasing number of CLO managers are seeking to lower weighted average spread requirements within their portfolios, according to Standard & Poor's. For example, "BB" and "BB" rated institutional loan spreads have tightened from more than 400 basis points over Libor in April 2003 to less than 200 basis points over Libor in July. And while the crunch has generally left enough space for the deals to squeeze past interest ratio coverage tests - a significant number of the deals are failing their weighted-average spread tests, according to the rating agency.
Of the 2001 vintage CLOs, 45% are failing their weighted-average spread requirements, and 40% of the 2000 vintage is failing, while the more recent 2002, 2003 and 2004 vintages are failing at rates of 15.8%, 11.3% and 7.40%, respectively.
And as CLO managers look to replace collateral within their deals that have either prepaid or simply paid down according to its amortization schedule, they're finding fewer and fewer options to satisfy minimum spread requirements within their portfolios. In lieu of being blocked from reinvesting principal proceeds, managers have searched for higher spread pickup in lower-rated collateral or diverged in loan type, or, most commonly, have sought to amend collateral spread requirements. A handful of recently originated CLOs have included refinance provisions that allow the manager to call some or all of the notes in order to refinance them at tighter spreads.
In the second quarter of this year alone, 27 CLOs have made one or more amendments to reduce the minimum weighted average spread, up from 13 in the first quarter and only three in the same time period last year, and 53 CLO's have executed the amendments since 2004. Among them include Champlain CLO Ltd., which closed in 2004 and executed an amendment in its spread requirement in the first quarter of this year, along with Hewett's Island CDO Ltd., also originated in 2004 and Babson CLO 2003-1, which completed an amendment in the third quarter.
CLO's stuck ramping up in the tightening spread environment have fared the worst. Deals issued in the third quarter of 2003 constitute the largest portion of weighted-average spread amendments. Those deals came about as "B" through "BB-" loan spreads fell from a peak of roughly 400 basis points and 375 basis points over Libor, respectively, to about 300 basis points and 240 basis points over Libor, respectively.
Weighted-average spread reductions have ranged from as much as 55 basis points to as few as three basis points. On average, the amendments have reduced the requirements in the range of 10 basis points to 40 basis points.
Not a single publicly rated CLO tranche was downgraded last year, and through Oct. 6, 11 have received upgrades. The relatively stable corporate credit environment, among other dynamics, has spurred a decline in leveraged-loan spreads.
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