Last month's upgrade of six classes of notes from The Carlyle Group's Carlyle Group High Yield Partners CDO was a rare event, with investors more accustomed to a stream of downgrades. But a number of CDOs could be primed for upgrade as a number of deals exit their revolving periods--when only interest payments are made and before principal payments--and the credit markets continue to improve. "The pace of downgrades will slow down, though it will not disappear. But we will see a pickup of upgrades, primarily due to deals maturing," explained Marion Silverman, a senior director at Fitch Ratings.
"Many deals [from the 1998-2000 vintage] are just starting to exit their revolving period and are now paying down debt," she said. In addition some have structural features that alter the capital structure. Examples include turbo features whereby excess spread is diverted to paying down the most expensive notes. Another version enables excess spread to instead be reinvested in new collateral, which also strengthens the OC tests and increases credit enhancement, Silverman added.
An improving credit market is also a factor after the heavy default environment of the last few years. The Carlyle Group's deal--which contains 75% high yield loans and bonds, and 25% mezzanine investments, private equity and distressed debt--is a market value deal that saw some strategic sales and a dramatic improvement in the credit markets, Silverman said. Other CDOs that have been upgraded include distressed debt CDOs, such as ARK CLO and Endeavour LLC mezzanine notes.
"The upgrades are a little bit of good news after a lot of bad news," said Stephen Anderberg, an analyst at Standard & Poor's. There have been approximately 10 downgrades to every upgrade, he said, pointing to a couple of static pool deals that were never downgraded that have seen some upgrades. CDOs such as those from C-Bass, and on the loan side the Swing Street CLO--a static pool of high yield loans from Deutsche Bank--have seen an upgrade as they delevered from day one, he noted.
But some of the downgraded deals could be showing upside. "Now that par erosion is leveling off for many of the transactions, a number of previously downgraded transactions could see a partial or in some cases even a complete restoration of the original ratings as the transactions continue to pay down senior notes due to the OC test breaches and restore credit enhancement," Anderberg said.