The well-documented struggles of the U.S. economy continue to pose increased difficulties for borrowers underlying U.S. middle market CLOs. Whereas early middle market CLOs benefited from solid performance of underlying middle market loans, the economic downturn has affected the viability of middle market companies resulting in a significant increase in defaults, which has contributed to negative rating pressures on middle market CLOs.
Evidence of this performance reversal was a recent string of downgrades and Negative Rating Outlooks by Fitch in its 2008/2009 rating review cycle of middle market CLOs. Of the 117 Fitch-rated U.S. middle market CLO tranches, 31 tranches were downgraded, 79 tranches were affirmed, and no tranches were upgraded.
Fitch anticipates further rating pressure for some middle market CLOs, as the Negative Rating Outlooks on approximately 30% of middle market CLO ratings will attest. Fitch also expects the increased frequency of defaults in the middle market loan space to continue for the near future, which may impact ratings further in the next review cycle.
Rating Drivers
The changing landscape of the middle market loan universe was paramount in reviewing the ratings of U.S. middle market CLOs. Recent portfolio credit deterioration was a major contributor to the negative rating actions. Fitch also applied its updated framework for rating corporate CDOs in this review process. Downgraded middle market CLO tranches no longer had sufficient credit enhancement at their previous rating levels to protect against weakening loan performance. For those tranches affirmed, Fitch determined that the available credit enhancement was sufficient to withstand the observed credit deterioration in that transaction's portfolio. Fitch assigned Negative Rating Outlooks to those tranches deemed to be at particular risk of elevated future defaults and lower than expected recoveries.
Rising Level of Defaults: At the conclusion of the 2008/2009 rating review for middle market CLOs, over 85% of the outstanding transactions reported at least one defaulted asset in their portfolios, compared to 30% a year earlier. In terms of borrowers, the number of unique obligors considered defaulted during the same period increased by more than 2.5 times to 53 from 19. Rising defaults resulted in generally lower credit enhancement for middle market CLO tranches, especially junior tranches that are first in line to absorb losses.
Revised Recovery Rate Assumptions: The impact of increased defaults was further magnified by Fitch's updated recovery rate assumptions for corporate debt, which were significantly lower for junior debt securities. Fitch's revised assumptions for junior debt impacted portfolios that contained large amounts of junior debt more significantly than senior secured portfolios due to the significantly more conservative recovery rate assumptions on these security types. Junior CLO tranches again displayed particular sensitivity, with relatively low credit enhancement levels making them highly susceptible to lower default recoveries.
As observed recovery rates became more depressed in the latter half of 2008, Fitch added sensitivity scenarios to its review process in 2009 to evaluate the impact of lower than expected recovery rates. For transactions reviewed in 2009, Fitch tested the sensitivity of the transaction structure to haircuts of 30% and 50% to its standard recovery rate assumptions for the entire portfolio. These results were used in conjunction with the base case to frame an overall picture of a transaction's vulnerability to potential shifts in future recovery rates. Fitch expects recovery rates for U.S. high-yield debt to continue to trend downward largely due to growing defaults, loan-heavy capital structures, aggressive lending standards and declining corporate fundamentals.
Portfolio Concentration Risks:Several middle market CLOs contained obligor concentration issues as a result of original portfolio construction with limited obligor diversification. Alternatively, some transactions experienced increased concentration through portfolio amortization. While underlying loan amortization is positive for noteholders in terms of principal redemption, these factors may lead to increased tail risk that a portfolio with less diversification is uniquely susceptible to the performance of a few obligors. Fitch identified seven transactions for which obligor concentration was of specific concern, with each containing no more than 43 unique obligors as of April 30.
Fitch's updated corporate CDO criteria incorporates it's view that concentrated portfolios will exhibit default characteristics that deviate from the historical data set against which Fitch's Portfolio Credit Model (PCM) output has been compared. To account for the potential deviations, Fitch's modeling framework provides for correlation adjustments based on inter-asset relationships in terms of industry, obligor, and geography. In some instances, overly concentrated portfolios, in conjunction with deteriorating portfolio performance, contributed to negative rating actions for middle market CLOs.
Middle Market Loan Collateral Outlook
The 2009 outlook for leveraged loans remains grim. Limited new issuance, weak buyer demand and higher trending default rates - all trends seen in the second half of 2008 - are continuing as 2009 draws to a close. Smaller, 'clubbier'-type leveraged loan deals that are tightly structured and highly priced will most likely represent the largest percentage of issuance this year. Second lien issuance was practically non-existent in first-quarter 2009 as investors remained risk averse amid signs of a deepening U.S. recession and rising default rates. Cash flow lending also continued to struggle in 1Q09. Instead, asset-based lending increased in the absence of real cash flows, so investors have hard assets to liquidate in a distressed scenario.
Looking forward, there is considerable default risk for outstanding leveraged loans for a number of reasons. First, refinancing pressures that began to emerge in late 2008 have continued into 2009. Ongoing tightness in the credit markets may result in viable borrowers with maturing loans in 2009 and 2010 unable to refinance. Second, the pace of defaults is expected to accelerate in 2009. Fitch's U.S. High Yield Default Index was 9.2% at May 31, which Fitch believes could reach 15% to 18% by year end and remain elevated into 2010. Finally, loan recoveries are expected to remain tested given the aging stock of loan-heavy capital structures with little to no covenants, lower market valuations and limited availability of debtor in possession financing.
The one variable in future performance will be the U.S. government and its proposed economic rescue plan. The credit markets, especially the leveraged loan market, could receive an instant boost from the clearing of "toxic" debt from banks' balance sheets and injection of new capital into the credit markets. These actions could potentially spark borrowing and lending in the corporate loan market once again. However, dismal economic prospects and higher trending default rates will likely temper new loan issuance for the remainder of 2009.
Future Rating Factors
The future performance of middle market CLOs will largely depend on the performance of the underlying loan collateral. Subordination and excess spread, which had once provided generous amounts of credit enhancement, have been eroded by increased defaults and negative credit migration. The following are some of the major factors that will determine the future performance of U.S. middle market CLOs:
Additional Credit Deterioration: Fitch has accounted for actual defaults, credit deterioration, and projected defaults in its current round of rating reviews. However, if future credit deterioration surpasses Fitch's expectations, additional negative rating actions remain possible in this sector.
Refinancing Risk: The current credit environment provides a degree of uncertainty in terms of the ability to refinance and/or renegotiate loan terms for loans that are scheduled to mature over the next one to two years. The ability (or inability) of issuers to refinance, repay, or renegotiate their loans will be a significant indicator of credit risk for those borrowers going forward.
Lower than Expected Recoveries: If future recovery levels are significantly lower than anticipated, further negative rating actions may be taken in this sector, especially to the junior notes. A potential combination of higher than expected defaults and lower than average recoveries could significantly impact the performance of transactions in this sector.
Operational Risk of Servicers/Originators: In a more stressful economic environment, the cost of servicing loans increases as more resources must be dedicated to the surveillance of existing loans, rather than the execution of new business. The ongoing ability of issuers to adequately monitor their loans and work out troubled assets will play a significant role in transaction performance.
Issuer Support of CLOs: Some originators have historically removed troubled loans from their CLO portfolios to restructure on balance sheet before they default. As a result of liquidity constraints, some originators have indicated that they will no longer be able to continue this practice, which may translate into higher defaults for middle market CLO portfolios going forward.
Transaction Structure: Payment structures and deal seasoning are just two of the attributes that can affect the future performance of both an overall transaction and its individual tranches. Fitch will continue to analyze each transaction to assess the impact that various structural features and portfolio characteristics has on each class of notes.
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