Rising interest rates could reduce an important form of credit enhancement for U.S. collateralized loan obligations, potential putting them at risk for downgrades in their credit ratings, according to Moody’s Investors Service.

In its October CLO Interest report, Moody’s said that increases in short-term rates, widely expected to take place next year, would be a “credit negative” event for U.S.-based CLOs because of the resulting reduction in credit enhancement called excess spread. This is the difference between the interest rate on the notes issued by CLOs and the interest rates on the loans that they acquire. Interest rates on both their liabilities and assets are expressed as a spread over the London Interbank Offered Rate, or Libor.

Moody’s warned that the impact of a spike in three-month Libor would be more pronounced in newer CLOs because a “greater portion” of the loans backing so-called CLO 2.0s, those issued since the financial crisis, include Libor floors. These floors, which can range from less than a percentage point to 1.5 percentage points or more, are designed to protect loan investors from falling interest rates, since the spread on a loan cannot fall below the floor, guaranteeing a minimum return. But when interest rates rise, the Libor floor also acts as an anchor.

“The most direct, and likely most significant, impact of rising rates on CLOs would be a roughly 75 bps decline in excess spread, which is a source of credit enhancement for CLOs,” the report, for which Moody’s researcher Jeremy Gluck was lead analyst, states. “This loss of excess spread would occur because the interest rates paid on CLOs’ mostly floating-rate liabilities will rise nearly in tandem with Libor, while the yields on CLOs’ floating-rate assets would not rise until Libor exceeds the relevant floor levels.”

Moody’s noted that most CLO 2.0s issued have included Libor floors of between 0.75% and 1.25%, with an average of 1%, and with Libor at around 0.25%, the Libor floor provides an asset spread boost of 75 bps. A 1% Libor floor, for example, could boost a CLO yield of Libor plus 300 bps to 400 bps over Libor plus.

“However, asset yields would increase if Libor rates were to rise above floor levels because those floors would no longer be binding,” the report states. “If Libor rises above the highest floor rate relevant for the assets in CLO collateral pools, then asset yields will rise at essentially the same pace as those of liabilities, halting excess spread compression.”

Moody’s Analytics expects that three-month Libor rates will “rise significantly” by early next year to over 1.00%,  eventually “surpassing all relevant floor levels during the first half of 2016,” or 2.00%. It projects that the three-month Libor rate will surpass 4.00% and plateau by the end of 2017.

A rate hike and spread compression would be particularly pronounced in CLO 2.0s, according to Moody’s, because of the more common inclusion of Libor floors in leveraged loans that comprise the collateral of these deals. More than 90% of loans held in CLOs issued in 2013 and 2014 have Libor floors.

One additional alarm for investors: about 70% of CLO 2.0 transactions would not be able to meet their current weighted average spread (or WAS) covenants if not for the “buoying effect” of Libor floors. In an examination of trustee reports providing assets spreads with and without Libor floor impact on CLOs, Moody’s found that the floors boosted WAS for CLO assets by an average of 73 bps.

“[T]hese deals may be able to shift to other combinations of WAS, weighted average rating factor, weighted average recovery rate and diversity score within their covenant quality matrices in order to comply with lower WAS covenants,” the report stated.

Another disadvantage for CLO 2.0s with reduced Libor floor impact is the fact their median subordinate interest coverage ratio is “slightly more” than 200 bps, or half that of 1.0 deals, Moody’s reported.

The impact of reduced excess spreads on investors could be mitigated by wider spreads in new loan issues. “If rates rise and floors become less relevant, lenders may demand wider spreads [on new loans] as compensation for the loss of value. For reinvesting CLOs, purchasing some new, cheaper loans would partially mitigate the negative credit impact of losing the excess spread Libor floors generated,” Moody’s stated.

Corporate borrowers might not feel the impact of higher interest rates right away, since the cost of their existing debt won’t change until Libor rates exceed the floors on these deals. But about one-third of all speculative-rated debt will be maturing within three years, and the rest within five. “Even if all this debt were fixed-rate, rates would be higher upon repricing,” the report states.

Moody’s Analytics forecasts that a 400 bps rise in Libor rates would result in a decline in the average CLO’s interest rate coverage to 2.6% -- compared with 3.0% in December 2013.

If and when Libor rates exceed floor levels, Moody’s stated, a CLO’s mix of fixed- and floating-rate assets will be crucial in determining the impact on excess spreads. Because of the Volcker Rule, newer CLO 2.0s do not have the flexibility to invest in fixed-rate instruments like bonds.

“Deals that hedge interest-rate risk by issuing matching fixed-rate liabilities can become under- or over-hedged as fixed-rate assets prepay or default at a different rate than that at which the corresponding fixed-rate liabilities mature,” according to Moody’s. “This is a greater concern for deals that are well into their amortization phases, when portfolio composition can change significantly.”

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