An unusual way of attracting investors in the riskiest slices of collateralized loan obligations is coming under scrutiny.
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 most subordinate class, known as the equity, is typically the hardest to place, because it receives no interest and is unrated, putting it off-limits to certain kinds of investors. So some CLO managers combine the equity with a more senior tranche, creating a new security with characteristics of both classes: it receives interest and is 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 are willing to assign ratings to combo notes.
Recently, however, Moody’s Investors Service has been rethinking just how risky combo notes are in light of the way that they are treated when CLOs are refinanced. Managers refinance CLOs to take advantage of lower interest rates, redeeming the notes (save the equity) and issuing new notes that receive lower coupon payments. When this happens, the higher-rated component of a combo note is stripped away, depriving it of the original rating support, while sharply reducing the remaining principal to the unrated subordinated assets.
This rarely happened before the financial crisis, when Moody’s began rating combo notes. But it is becoming increasingly common.
When this happens, Moody’s has been downgrading combo notes, sometimes by three or more notches, as it did with the comb notes of a pair transactions that were from completed by CVC Credit Partners and Carlyle Group in 2012 and refinanced in April 2015.
Now the ratings agency is mulling whether to revise its ratings methodology for combo notes or refrain from rating them altogether.
“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. “In the presence of such refinancing risks, Moody's proposes incorporating refinancing scenarios into the credit analysis of combo notes.”
The proposal does not sit well with Loans Syndication and Trading Association; the trade group has warned that it could prompt holders to dump the notes and devalue CLO holdings.
“We feel it imperative to advise that any changes to Moody's current methodology would unnecessarily stymie the CLO market by depriving it of an important resource for optimizing CLO products to investor demands,” the LSTA stated in a June 10 comment letter.
Both the LSTA and Moody’s declined comment on the matter beyond their published comments.
CLOs aren’t the only types of deals that issue combo notes; they are also issued by collateralized debt obligations. However, CLOs account for the majority (135 of 210) of the outstanding combo notes, according to Moody’s. Of these 83 were issued before the financial crisis and 67 were issued by European CLOs.
In June 2012, CVC Credit Partners issued a $10 million combo notes package tied to its $263.7 million Apidos CLO IX transaction – a CLO with a July 2016 maturity date. Moody’s assigned a ‘Baa3’ to the notes, which were comprised of $7 million in class B notes and $3 million in equity. The rating agency upgraded the combo notes to ‘Aa2’ in October 2014, after distributions to the equity tranches had reduced the principal amount to $8.4 million (the class B notes payments applied only to interest to that point).
But in April 2015 Apidos CLO IX was refinanced, resulting in the early redemption of the class B notes, decreasing the combo notes securities overnight to $1.08 million. Moody’s subsequently bumped the combo notes ratings down to ‘Ba2’.
Moody’s believes that investors should know from the outset that a refinancing could result in premature reduction of principal and ratings. “As the combo note often has very few components, such refinancing, while infrequent, can represent a sudden and significant change to the credit profile,” Moody’s stated in its request for comment.
Moody’s proposed methodology change is to not only include refinancing risk, but to rate the combo notes on their expected contractual payments of the principal and interest to full maturity – rather than just the principal. This could lead to downward ratings pressure on existing notes, Moody’s warned.
The LSTA believes that despite their infrequent issuance, combo notes play a crucial role in attracting a wider pool of investors into CLOs. These investors want the higher returns of CLO equity but are precluded from taking part in unrated instruments like equity, or would have unacceptably high capital costs in directly investing in that particular tranche.
The LSTA believes it would not only be a mistake to discontinue ratings for combo notes, but also Moody’s ideas to exchange the methodology that currently rates the notes based on the principal (or the “stated balance”) returns for one that considers the contractually promised payments, or essentially the principal and interest due at maturity.
The LSTA stated in its letter that investors “expect and understand” the possibility of refinancing and the resulting ratings volatility when they take the plunge. Additionally, “any such downgrades resulting from such refinancings or redemptions are structural, rather than credit-related, and thus the investors are not adversely impacted by the events precipitating such downgrades,” the LSTA letter stated.
The changes to methodology would decrease that demand, and present “yet another setback for the CLO market, which has struggled keeping pace this year with the issuance level over the past two years, due to regulatory and macroeconomic challenges facing the market.”
Moody’s has not issued a timeline on its decision over whether to revise or drop the combo notes ratings methodology.