Standard & Poor's expects to write 21 confirmation letters this quarter for collateralized loan obligations looking to lower the weighted average spread (WAS) covenant. The rating agency wrote 20 rating confirmation letters in all last year. "Many deals are accumulating cash and are approaching the weighted average spread triggers," Stephen Anderberg, director of CDO surveillance at Standard & Poor's stated. Managers have requested reductions between 10-50 basis points on CLOs.
Spread contraction and prepayments in the leveraged loan market have left managers with several options to avoid breaching spread covenants. Some CLOs have provisions that allow the manager to re-finance the CLO notes and re-issue them at a lower spread, a tactic adopted by several managers in the past year.
Another option is to lower the spread covenant. This requires noteholder approval and a letter from S&P stating that approval of the amendment will not, in and of itself, lead to the lowering of the ratings assigned to the CLO. The WAS amendment typically requires majority or 2/3 vote of CLO noteholders. According to Anderberg, S&P has accepted most of the requests, but it is not a binary issue. He explained a manager could ask for a 60 basis point cut but will be told a 30 basis point cut would be approved.
Another option, which only one manager has used to date, is loosening the credit quality trigger on a deal. This allows the manager to invest in riskier loans, thereby increasing spread. This could be perceived as an equity friendly move that does not require a reduction in the weighted average spread. However, in the event of rising defaults or credit migration, it could also be a risky tactic. Anderberg declined to name the manager.
Finally, if a manager is unable to purchase new loans because there is no room left in the portfolio WAS test, the manager can also allow the CLO to accumulate principal cash as the loans in the portfolio paydown. This has occurred for a handful of older vintage CLOs already at, or nearing, the end of their reinvestment periods, particularly where deals had been failing other eligibility criteria tests that would have made it difficult to reinvest the cash anyway. But this is not feasible for deals with significant time left in their reinvestment periods, since it will cause negative carry.