Thanks in part to a low default rate, 2005 was a strong year ratings-wise for collateralized bond obligations and collateralized loan obligations, according to a recent report by Standard & Poor's.
Only two CLO tranches were downgraded and 22 were upgraded. CBO managers saw 50 upgrades compared with only 15 downgrades, representing a significant improvement over 2004's 26 CBO upgrades and 23 downgrades. The mild credit environment that characterized 2005 is, in part, why it was a strong ratings year for the vehicles.
Structural factors were also a key driver for CBO ratings actions, the report said. As many of these vehicles were outside their reinvestment period, managers were putting proceeds toward amortizing senior notes, which restored credit support to the senior tranches that were stressed during the downturn a few years ago.
However, not all of the upgrades can be attributed to de-levering.
"An increased number of calls on high yield bonds in the collateral pools accelerated the rate at which many senior tranches from numerous transactions paid down," S&P said. "In addition to garnering more upgrades, the bond calls also resulted in upgrades of greater magnitude than might have otherwise occurred. Instead of accumulating a few million dollars in principal cash with which to de-lever on a given payment date, some high yield CBO transactions ended up with enough cash to pay down huge portions of their senior notes on a single payment date, leading in some cases to precipitous upgrades."
S&P has a positive outlook for the senior tranches of CBOs. It expects to issue additional upgrades this year as more managers reduce the leverage of senior tranches.
CLO weighted average spread tests under stress
The news wasn't entirely positive when it comes to CLOs.
Though leveraged loans remain a top choice of debt financing among corporate issuers, one of the drivers behind the loan product's popularity - rock-bottom Libor spreads - has proven to be a thorn in CLO managers' sides.
Low spreads, coupled with high prepayment rates, drove CLO managers to amend the minimum covenanted weighted average spread rate for a record 58 CLOs in 2005, according to S&P.
"As spreads on new issue leveraged loans have decreased over the past several years, many CLO managers with transactions issued in relatively higher spread environments have been unable to source new collateral at spreads equivalent to those of the loans paying down," the report said. "The problem has been exacerbated by a significant acceleration in prepayment rates on leveraged loans, as borrowers are taking advantage of the opportunity to refinance their loans in a lower spread environment, increasing the rate at which portfolio weighted average spreads have declined."
S&P said in some instances the cushion between the actual portfolio spread and the minimum requirement was completely eroded, making it nearly impossible for CLO managers to obtain collateral with ample spreads to keep weighted average spread tests above water.
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