After unveiling plans in January to change the way it rates U.S. bank loans and bonds, last week Moody's Investors Service extended its 30-day comment period, which now ends March 31.
While the new methodology reinforces a view that bank loans have a stronger performance than initially thought, the U.S. CLO market has become increasingly concerned about possible jolts. Potential for spread tightening and the impact, if any, on structured finance vehicles appears to be at the core of the angst.
The new methodology aims to introduce both loss-given default and probability-of-default into its ratings of non-financial speculative-grade corporate issuers.
The new rating methodology would be applied to U.S. speculative-grade corporate issuers, with plans for a European rollout later this year. However, the U.S. universe alone encompasses between 2,400 and 2,500 speculative-grade issues, and could take from six to 18 months to comb through, depending on how far back Moody's chooses to go with the new methodology.
Moody's managing director Michael Rowan said the decision to extend the comment period was a logical outcome of feedback from the market.
"In this case, it could have an impact on a large number of ratings. Market participants said they would appreciate more time to evaluate the potential that this methodology could have, and we decided more time would be appropriate," Rowan said.
While the new methodology will apply to newly minted deals once it's released, the ratings agency has not announced which period of existing bank loans rated under the old methodology would be re-rated. Some market participants predict a "facilities rating contest" could come into play.
Newer CLOs could allow for more leverage, said Sanjeev Handa, head of ABS and CDOs at TIAA-CREF, which has invested $465 million in the CLO market. A sponsor could buy leveraged loans that have a facility rating greater than the credit rating, which would allow for an increase in leverage.
"And an increase in leverage would be positive for equity returns," Handa said.
Under debate right now, however, is if newer deals allow for more leverage because of the facility-rating concept and "what does that mean to our risk-return profile? It's an interesting discussion that I think all buysiders are going to have if the facilities rating contest comes into play," he said.
In a recent presentation made to the Loan Syndication and Trading Association about the changes, Moody's estimated nearly 60% of the loans it rates would be impacted - by moving up a notch or two. Moody's research shows that credit losses on bank loans have tended to be lower than those for similarly rated corporate bonds. But in a world where a view on debt is delicately balanced on ratings, a positive climb nonetheless has large-scale implications.
The potential for tightening of spreads in a market already trading at historically tight figures is another area of concern. Tighter spreads on newly minted bank loans could make it more difficult for CLO structures to buy new collateral to place into existing CLOs. The market could bid up the prices of facilities with a higher rating than the corporate rating, he noted.
And as existing deals have certain reinvestment criteria, CLO managers are facing possible changes to CLO documentation, a process easier said than done, as it requires negotiations with CLO investors.
Also, estimates from UBS' CDO research team, in a conference call last week, predicated that if loan spreads tightened 25 to 50 basis points, it could make it more difficult to attract CLO equity investors due to a decrease in the arbitrage offered.
But changes stemming from more highly rated bank loans are not limited to the CLO world. Another implication of a lower spread environment in loans is the possibility that older CLOs would no longer be able to stay within their weighted average spread tests. This has potential ramifications for the CDO market, which purchases CLOs to package into its own vehicles.
"If the weighted average factor changes because the way the loans are rated now differs, what does that do to the rating of the vehicle? It doesn't appear they have considered the implications for CDO vehicles yet," said a CDO asset manager who is still reviewing the impact of the proposals.
"We're looking for consistency and clarity," with respect to the issuer methodology changes, "and the implications for structured vehicles," said Michael McAdams of Four Corners Capital Management. The Los Angeles-based corporate loan money manger has $3.5 billion under management and has issued two cash flow CLOs.
The bank loan market generally appears to be slowly digesting the proposed methodology changes. Standard & Poor's implemented a new suite of recovery ratings for bank loans in 2003. About six months ago, Fitch Ratings launched a new methodology targeting recovery ratings for corporate finance, which touches on bank loans. It appears Moody's has come under scrutiny because the new system would still harness a single expression to explain its improved opinion about loss-given-defaults. Moody's LGD ratings would be integrated into its long-term bond and loan ratings.
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