Moody’s Investors Service has downgraded the millions of $248.9 million of some of the riskiest securities issued by collateralized loan obligations so far this month as the result of a change in its rating methodology.
The rating agency is taking a harder look at “combo” notes, a hybrid debt/equity instrument, to account for what happens to them when a deal is refinanced. As a result, it has put the ratings of the combo notes of 38 CLOs under review for possible downgrades.
It’s nearly halfway through, having confirmed or downgraded the structured finance ratings on 16 “combo” note CLO tranches this month, a search of its website indicates.
Since Dec. 6, Moody’s has downgraded the combo notes of 10 CLOs, and confirmed ratings of six others, from outstanding deals managed by the likes of Babson Capital Management, Credit Suisse and PineBridge Investments.
In most cases, the downgrades were only one or two notches, leaving the combo notes with a lower-level investment-grade rating. All of the affected deals thus far were completed in 2015 and 2016.
Combination notes in CLOs are specialized tranches of hybrid debt and equity, which tether the unrated equity notes tranche to a higher-rated one that supports an investment-grade rating for the combined securities offering.
Combo notes account for a fraction of the notional value of the notes issued by CLO, but they allow managers to widen the institutional investor base for the most subordinated securities issued in such deals, known as the equity. Equity tranches are typically unrated and so either unatttractive or off-limits to many buyers. By bundling the equity together with more senior class of securities, managers create an offering that is less risky and carries a credit rating.
Earlier this year, Moody’s put in motion steps to reconsider how it rates such combo notes that are included among 135 rated outstanding CLOs. The agency expressed concerns that in a refinancing, some deals stripped out the rated portion of a combo note, forcing Moody’s to apply a multiple-notch downgrade on a combo notes’ rating, often to speculative-grade status.
The move was opposed investors and managers alike. Many in the industry thought it might narrow the investor base for CLOs, or prompt a sell-off that could drive down prices on CLO paper in the secondary market.
In adopting its new methodology in October, Moody’s added a potential refinancing scenario. The agency had considered dropping the ratings on combo notes altogether.
In addition to the 10 downgrades so far, six other deals had their ratings confirmed, including two CLO portfolios managed by Voya Alternative Asset Management (Voya CLO 2015-2 and Voya CLO 2014-3).
The overall balance of the combo notes with downgraded or confirmed ratings this month is $608.15 million, ranging from $14.9 million to $107.1 million in size.
One CLO, Babson’s CLO 2015-II deal with a balance of $35.7 million, had the steepest downgrade of three notches, from ‘A2’ to ‘Baa2’.