While leveraged loan ETF and money market funds face an unsteady near-term future amidst ongoing retail investor outflow, the CLO market is rolling towards its busiest year ever. With year-to-date global issuance at approximately $98 billion (with $89 billion or so in the U.S. alone) as of mid-September, many market commentators see $125 billion in total U.S. CLO issuance by year-end as a real possibility. Recent reports calculate that CLOs accounted for nearly 60% of new issue institutional leveraged loan demand in the first half of 2014. As new collateral managers continue to enter the market and the industry has recovered from the Volcker Rule chill of mid-winter, market actors are now preparing to deal with the challenges that the forthcoming U.S. risk retention rules will inevitably present.
With all of the above news dominating the CLO headlines, some market observers may have missed a less heralded development in the CLO market, which is very likely to have an impact on both the CLO market and the leveraged loan market. On August 1, 2014, S&P released an updated CLO rating methodology that provides for a more nuanced classification of recovery assumptions related to the assets acquired by CLOs. The challenges and opportunities presented by the updated S&P methodology are worthy of attention.
Generally, S&P assigns a recovery rating to a CLO’s loan assets of “1+” to “6” from which the recovery rate of the particular asset is determined for purposes of S&P’s CDO Monitor Test. Broken down into its simplest elements, the updated S&P criteria bifurcates each recovery rating in categories ‘2’ through ‘5’ (see below).
Prior to the change, recovery rates for categories ‘2’ through ‘5’ were determined using only the lower of the two bands in each category. In other words, when evaluating recovery rates for the “AAA” tranche, each asset with a ‘2’ recovery rating was assigned a recovery rate of 50 for testing purposes, each asset with a ‘3’ recovery rating was assigned a recovery rate of 30 and so on. This revised tiered recovery rating assumption is expected to lead to increased cushions in recovery rate tests in CLOs that are amended to incorporate the updated criteria, as one would expect a material number of the assets in a CLO portfolio to fall into the upper band in the applicable recovery rating category.
As fun as it is to wade through the technicalities of the ratings criteria changes, let’s discuss what this methodology change means for CLOs and the leveraged loan market. Collateral managers may benefit from the new criteria in one of two ways. First, managers may seek to add cushion to their recovery rate tests. In this scenario, managers would maintain the same (or a very similar) portfolio and hedge against future instability by adding ratings cushion to the portfolio.
A second possibility is that managers will seek to maintain the current recovery rating of a deal’s portfolio while acquiring lower rated (read: higher yielding) assets. A recent study compared yields on assets by recovery rating and noted that loans in the “upper tier” of recovery rating category ‘2’ have yields that can be up to 50 bps wider than yields on loans in the recovery rating category ‘1’. Yields for loans in categories ‘3’ and ‘4’ can be up to 100 bps wider. Managers that utilize the new S&P criteria to widen spreads would increase returns to equity investors while maintaining the stability of the deal’s current portfolio.
The increased appetite for higher yielding loans will likely be felt in various ways across the leveraged loan market. First, as noted above, if demand for lower yielding category ‘1’ loans decrease, prices are likely to follow. Second, issuance of higher yielding recovery ratings ‘2’ through ‘5’ loans could increase to account for increased demand. Third, increased leverage and demand for higher yielding loans from CLO funds could cause yields to tighten in the leveraged loan market.
Managers and investors can’t simply sit back and wait for the cows to come home. S&P’s release made clear that it will not migrate ratings on existing CLOs to the updated method. Managers and investors will have to amend deal documents in order to accrue the benefit of this methodology change. In certain cases, amendments may require controlling class consent, and the controlling class may require equity investors to accept Volcker Rule changes as the proverbial quid in exchange for the updated S&P recovery ratings quo. The Volcker Rule restrictions imposed by controlling class holders may negate some of the yield benefits from the S&P recovery ratings update. Some deals have already submitted amendments including S&P changes to holders while other managers are working to do so. The Volcker/S&P balance that will be struck between controlling class and equity class holders remains to be seen.