The discounted security threshold — usually where assets bought below 80 or 85 cents in the dollar are counted at purchase price but assets bought above this level are counted at par for the purpose of the over-collateralisation tests — has caused CLO managers problems since leveraged loan prices dropped last September.
Almost all are trading below 85 cents and the threshold is causing problems for managers who want to improve or maintain the quality of the underlying collateral. "There is a disincentive for a CLO manager to make substitution trades, which may be needed to improve the credit quality of the underlying pool of loans," said Fitch.
Fitch is concerned about issues investors may face if they agree to waive the discounted security threshold. Managers could be encouraged to buy assets trading well below market price to pass over-collateralisation tests, for example.
But it believes investors may be able to use other methods to reduce the risk of this happening.
Investors could analyse the risk of discounted purchases by looking at whether new assets bought at a discount have better or worse characteristics than the overall portfolio or whether they are trading well below market prices. They could use an index based method to do this.
Fitch suggests investors look at the manager’s alignment of interests. For example, a manager that owns equity or is dependent on subordinated fees — fees that are shut off if junior overcollateralisation tests are triggered — may have a greater incentive to buy discounted assets to pass over-collateralisation tests rather than to improve the credit quality of the portfolio.
The agency also encourages investors to look at how the rated notes perform when analysing the portfolio based on acquisition cost rather than par. This could be especially useful on weaker portfolios or new deals where the whole portfolio is bought at discounted prices.
