The rate at which loans backing CLOs default has historically varied “significantly” between managers, according to a study published last month by Moody’s Investors Service.
The wide range of collateral defaults of 18 managers tracked in the study – between just over 5% to well over 8% (see chart) – seems primarily a reflection of the disparate risk levels that managers are willing to undertake, Moody’s researchers noted in a first-of-its-kind look at the long-term trends of default rates specific to particular firms.
The study covered collateral default performance in CLOs from 2002 to 2014, based on trustees reports.
What stood out, according to Moody’s was the correlation between default rates with a manager’s weighted average rating factor (or WARF), which is a numerical representation of the underlying ratings of loan assets purchased by managers.
An ‘AAA’ rating scores a 1 in Moody’s WARF calculations; a ‘Ba1’ – the highest speculative-grade rating – would factor in a score of 940; a bottom level, pre-default rating of ‘Caa3’ is measured at 8070. So the higher the score, the higher the risk.
LCM Asset Management LLC, for instance, recorded the lowest pro forma default rate during the study period, and had an average WARF figure by manager of 2295. In contrast, the 8.49% default rate of Pacific Investment Management Co. (the highest default rate among the 18 firms) had the highest WARF average of well at 3134.
While WARF can be an indicator of credit deterioration prior to default, they may also reflect riskier portfolio strategies of managers with the appetite to seek out higher-yielding assets.
Jeremy Gluck, a research analyst in Moody’s structured finance group, said the study was limited to examining whether WARF – and other leading indicators like the general speculative-grade default rate -- is a leading indicator of CLO collateral defaults.
“We certainly did not go in depth into different manager strategies and how they dealt with risky assets,” said Gluck. “We were only looking at ratings as a possible indicator of future defaults.”
In the default rate table, the three lowest WARF ratings belonged to the agencies with the lowest default rates as well: LCM, Stone Tower Debt Advisors LLC at 5.64% (Stone was acquired by Apollo Global Management in 2012) and Octagon at 5.67%.
But WARF wasn’t always a direct indicator of the differing default rates among managers. Babson Capital held the sixth lowest default rate at 6.62%, but had the second-highest WARF figure of 3098.
The study also indicated that CLO collateral default rate patterns reflected that of the speculative grade market. The spec-grade default rate was generally between the “pro forma” and “realized” CLO collateral default rates, which are differentiated by a CLO’s original assets and after a manager sells off potential defaults from the portfolio.
The pro forma CLO assets were generally 5.07% during the period, and the realized rates (after the sell-off were 3.41%.
“We think the pro forma rates are probably more meaningful than the realized rates,” in determining CLO manager performance, said Gluck. “The issue with the realized rates is that managers may very well sell assets shortly before it defaults…For example, they may have incentives to sell assets to meet overcollateralization tests.”