Moody's Investors Service is trying to head off more criticism about the effect its new ratings will have on collateralized loan obligations, issuing responses to the comments levied by market participants. Many CLO managers are up in arms about the new methodology, which would increase ratings one or two notches on loans, and in turn could lead to a mass of repricings, causing problems for existing portfolios.
The market is concerned that loan spreads will decrease as a result of the ratings upgrades, which could also trigger spread-reset provisions or a wave of refinancing. Another concern is that liquidity might contract.
The agency has issued a 12 page response after speaking with market participants. It had received feedback after presentations to the Loan Syndications and Trading Association and the Bond Market Association, and at several CLO conferences. "One of the primary concerns is the impact on the loan market and understanding how it would impact the CLOs and the different portfolios that managers are currently managing," said Mike Rowan, Moody's group managing director and co-head of corporate finance in the Americas.
The agency stressed that not all loans will be upgraded and that some loans cannot reset based upon rating changes alone. On a broader view, the ratings agency says the proposal would actually put some loans beyond the reach of CLOs, and the reduced demand would eventually cause spreads to widen.
One portfolio manager didn't quite agree with Moody's last assertion. "Some [credits] that are double-B are going to become investment grade and their argument is, don't worry about it, sure spreads are going to come down but you'll make it up because of the recovery we are going to permit you to take into account. But that is not true because the recovery you are allowed to assume is more conservative," he said.
The effect on older CLOs will depend on whether the portfolio's reinvestment period has ended. The minority that are still within the reinvestment period, says Moody's, may be able to adapt to spread compression without an indenture amendment by spending their weighted average recovery rate (WARR) on lower recovery-rate/higher-spread assets. The agency is quick to point out, however, that it neither encourages nor discourages doing so.
Moody's offers a few suggestions on how current CLOs can prepare for the proposed changes. One way is by considering an expansion of a portfolio's synthetic basket. Most recent CLOs have a synthetic basket for as much as 20% and Moody's will consider proposals to increase the size of the basket to more than that, because synthetics may allow a CLO to trade recovery for spread within a single asset. The agency also suggests CLO managers change their reinvestment rules to allow for substitutions of a refinanced loan, even if that substitution could cause a weighted average spread test violation.
