J.P. Morgan is raising concerns that reinvestment risk in collateralized loan obligations may lead to an effective call on the transaction if interest coverage tests are not satisfied. Christopher Flanagan, managing director of global structured finance research for JP Morgan, notes that as leveraged loan spreads continue to hover near record lows, seasoned CLOs face reinvestment risk as existing assets prepay. In a research report, he explains that prepayments are running at 25% a year or higher. Reinvestment risk may lead to an effective call on the transaction if interest coverage (I/C) tests are not satisfied.
So far, although loan collateral hasn't gotten any cheaper, I/C has increased in 2004, he comments. "To us, it appears that many asset managers are trying to forestall noncompliance by rotating into yielder assets." He adds that this is a risky strategy, since higher yielding assets are more likely to default, causing the deal to unwind, and effectively triggering prepayment at par or less.
"The entire loan industry is facing spread compression, high levels of refinancing and called assets," said Ashleigh Bischoff, an analyst at Fitch Ratings. She added that many loan deals have high levels of cash balances. However, she pointed out that compressing spreads do not always lead to downgrades because Fitch rates to the minimum and maximum covenant levels. "In some cases, the rising prices of high yield loans have helped asset managers harvest gains especially in the case of previously distressed securities," she added.
But there are some managers that are feeling the squeeze. "Since the start of the year we have had several requests to change the average spread covenants on both ABS and corporate cashflow CDOs," Bischoff notes. "If spread compression continues, it is likely that we will see more requests for weighted average spread adjustments."