Managers of collateralized loan obligations seeking to attract more investors for their deals’ most subordinate – and risk-laden – securities tranches are increasingly turning to an old tool to boost demand: the combo note.
Since last fall, CLO managers including Conning’s Octagon Credit Investors, Tennenbaum Capital Partners and Ellington Management Group have launched new deals with so-called combination notes that blend portions of unrated equity notes with higher-rated debt securities into a single, unified tranche.
The resulting hybrid note offers the higher returns of the lower-ranking notes but with the support of higher-ranking notes that help support an investment-grade rating for the new security.
“The combo notes are ultimately about getting more of a return for the rating level,” a CLO manager told Asset Securitization Report.
CLOs issue combo notes to attract institutional investors – notably insurance firms – that have restrictions on investing in speculative-grade or unrated assets.
Publicly rated combo note deals had not been commonly issued in recent years as managers found enough demand to place notes as is.
Additionally, the exit by Moody’s Investors Service from rating combo notes three years ago was a move that industry insiders viewed as a hindrance to both issuance and investor interest.
But insurance companies and other big institutional investors have newfound attention in buying higher-returning equity stakes in CLO deals. With other ratings agencies stepping up their coverage of the offerings, demand for combo note deals has intensified.
“You’re seeing more deals pursue insurance companies via the combo, because it’s harder to place third-party equity right now,” said Eric Hudson, a managing director at Kroll Bond Rating Agency. “The insurance company’s hurdle may not be as high as a hedge fund, since it wants downside protection by blending investment-grade tranches with the equity.”
“They like that it has a pretty good yield and allows them to participate in the equity, but also in a rated form,” Hudson added.
CLOs pool payments from multiple below-investment-grade corporate loans and pass them on to different classes of owners in various tranches of securities.
The combo note structure inoculates against the risk of losses by pairing the first-loss, no-interest equity tranche with the higher-rated tranches.
“By holding various layers of a single transaction, the combo note can achieve higher income from the equity and lower rated tranches, and still have protection in downside scenarios due to the holdings of investment-grade tranches,” Kroll stated in a recent report.
“This blending of notes and equity prevents the combo notes from incurring large losses, while providing an enhanced yield.”
Combo notes can be formed with almost any mix of the rated tranches, including the triple-A classes. As CLO managers combine the equity with a more senior tranche, they create a new security with characteristics of both classes: It receives interest and has certain rights, such as the right to terminate a manager for cause and the right to consent to amendments and other actions of the CLO and the manager.
Importantly, credit rating agencies other than Moody’s are willing to assign ratings to combo notes.
Since last December, DBRS has published public ratings on two middle-market CLOs issued by Tennenbaum with combination note ratings. The TCP Rainier LLC ideal issued in December included a principal portion of the Class A, B, C and subordinate notes (the amounts were undisclosed in a DBRS release) combined into a provisionally rated (BBB-low) note.
The BBB-rated combination note issued with Tennenbaum’s TCP DLF VIII 2018 included five classes of notes plus the equity, but excluded principal from the AAA-rated Class A-1 notes, according to a DBRS release.
In March, Kroll assigned a BBB+ rating to a $10 million combination note issued by the distressed-asset manager Ellington that combined $8.38 million of Class D, E, and F note principal with $1.62 million of equity notes.
S&P had a preliminary investment-grade rating (BBB+) rating for a secured CLO repack note to be issued by Oaktree Capital Management, but the transaction was pulled in April, according to an S&P presale report.
Oaktree initially offered the $155.7 million Oaktree 2019-1T Secured Note as a repack of the senior and subordinate notes totaling $33.8 million (carrying ratings ranging from AAA to BB-) as well as the equity tranche of $55.01 million of its $743.2 million Oaktree CLO 2019-1 deal.
S&P otherwise carries ratings for only 14 combo notes issued since 2017. Fitch Ratings carries ratings on six CLO combo notes issued in 2016 and 2017. (Most combo notes are issued within CLO capital stacks.)
Refinancing risk
One of the combo-note risks Moody’s spelled out three years ago was how a subsequent refinancing could strip out the investment-grade support for the lower equity tranche.
Since 2016, Moody’s has stopped rating combination securities in which the “secured debt and equity tranches that have a rated balance that differs from the entire contractual promise of these securities,” the agency announced at the time. That followed a series of combo note downgrades Moody’s performed – some as much as three notches.
In one example, a June 2012 CLO from CVC Credit Partners included a $10 million combo notes package with its triple-B equivalent ‘Baa3’ rating, with a $7 million Class B notes tranche supporting a $3 million equity tranche that otherwise would have been unrated.
After an upgrade to ‘Aa2’ two years later when some principal had been repaid, a 2015 refinancing stripped the package of the Class B note support – and the remaining combo note securities were backed only by the equity. The combo tranche was downgraded to Ba2.
“As combo notes often have very few components … refinancing can represent a sudden and significant change to their credit profile,” Moody’s stated in a request for comment published in April 2016. Moody’s initially proposed incorporating refinancing scenarios into the credit analysis of combo notes, which the Loan Syndications & Trading Association opposed.
While dropping the ratings for new deals, Moody’s also placed 38 CLOs with combo notes under review for a downgrade. Its review involved firms such as Babson Capital Management, Credit Suisse and PineBridge Investments.
Kroll acknowledged the refinancing risk in its report, with the potential for redemption of notes prior to maturity that leave a combo note holding only equity.
But Kroll noted ways managers mitigate the risk: a combo note holder with equity can simply use control of the deal to prevent a refi. Legal documents could also be included preventing the future refinancing of combo note principal.
(Ratings assigned to combo notes are typically tied only to principal repayment, which will be slightly higher than an assessment that also stress-tests a portfolio’s cash flow repayment on interest.)
For investors willing to look beyond investment grade altogether, some recent combo note offerings have drawn on debt that is below investment grade.
Five Arrows Managers North America is offering the Class B and C noteholders in the $405 million Ocean Trails VII transaction via Credit Suisse the chance to exchange their fixed-rate notes for equal-sized combinations of fixed- and floating-rate tranches, all within the same class. A Class B investor receiving Libor plus 200 basis points, for example, could opt to trade out for a combo tranche with a variable-rate note paying a 190 basis point spread along with a fixed-rate note with a coupon of 0.1%, according to a presale report from S&P.
Five Arrows, the CLO management arm of Rothschild North America Holdings, is offering four different combo options of fixed- and floating-rate tranches for both Class B and Class C investors, S&P’s report stated
