European CLO Managers Underreport Cov-Lite Exposure

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Managers of European collateralized loan obligations are underreporting their exposure to loans that lack certain investor protections, according to Moody’s Investors Service.

The rating agency blames the lack of standard terminology used to describe covenants that forbid borrowers from taking certain actions or require them maintain certain financial ratios, most typically leverage (the ratio of debt-to-equity), interest coverage and cash coverage.

In Europe, as in North America, the “cov-lite” loan label is typically applied in a binary fashion: below-investment grade covenants either have maintenance covenants or they don’t.

This approach “masks the fact that covenant protections exist on a spectrum, and investors cannot fully assess credit risk unless they know precisely how the cov-lite label is defined and the underlying protections are applied,” the rating agency stated in a report published Thursday.

Moreover, it’s left to a CLO manager to determine within its “reasonable” or “commercial” judgement, whether a loan is cove-lite, “which leaves some room for discretion, and makes any qualitative comparison across different transactions and/or collateral managers difficult, if not impossible,” the report states.

Moody’s has created a third category, “covenant-loose,” for loans that have one or two financial maintenance covenants, but not a full suite. (When loans have a single maintenance covenant, it typically relates to a net leverage ratio.)

While CLO managers are under-reporting their true exposure, there does not appear to be any adverse selection of loans. The rating agency calculates the average exposure to cov-lite loans in European CLOs issued since the financial crisis at 37%. This is only slightly higher than exposure in the broader European loan market of 29%.

The difference is even less when including covenant loose loans, with CLO 2.0 exposure totaling 88% compared with the 83% in the general market.

Although CLO 2.0 portfolios broadly mirror the overall market in terms of covenant quality, a higher share of loans with weaker covenant structures does not necessarily negatively impact CLO performance. That’s because Moody’s takes covenant protection, as well as covenant headroom, into account in its credit analysis of deals. Actual covenant protection is reflected in the rating agency’s assessment of loss given defaults on loans held in CLOs. It also consider covenant headroom in the context of specific situations in order to derive a rating.

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