Thursday, October 29, 2009

"and yes I said yes I will Yes."

The Wall Street Journal reports this morning that Dallas-based Highland Capital is putting together three CDO deals backed by corporate loans, one of which “will have no credit ratings at all.”


Highland is using the wide-spread investor dissatisfaction with rating agencies as a “screen” for not wanting to rely on them for CLO ratings.

Highland might wish to make the argument that the credit rating agencies (CRAs) are an unnecessary expense to the deal and that they are inaccurate anyway, right?

If, as a potential investor, you’re open to be swayed by this argument alone, we would ask you to consider at least three areas where we believe you will be losing out absent a rating:-

Structural Protections

While we have been critical of certain CRA ratings decisions, including in the CLO space, it is clear to us that underwriting quality has improved over time on the CLO documentation side. The rating agencies have learnt various lessons and imposed new restrictions over time to protect against what they believed were aggressive loan management plays, or against loan managers’ aggressive interpretation of the terms of the indenture. These “lessons” resulted in, for example, the implementation of the triple C bucket haircut (see here), which aims to disincentivize managers from building “fantasy” par or interest coverage by buying lowly-rated securities.

The CRAs, in other words, have warmed over time to the tricks of the aggressive management trade and have built in certain structural protection to protect the rated noteholders.

(Highland, like many other CLO managers, often hold an equity or residual stake in their own deals, and so may be otherwise incentivized to “flush” proceeds as interest proceeds down the CLO waterfall to the equity tranche. The “game” is thus for the rating agencies to protect their rated noteholders, ensuring only the justifiable proceeds are being alloacted for distribution to the equity holders and out of the deal, according to the design or "spirit" of the deal. More can be read on managers' interests in the CLO, and potential conflicts of interest in managing across the capital structure, here.)

Absent structural protections and rating agencies, who or what will protect the noteholder against a manager's running amok?

An Extra Eye on Deal Terms and Analytics

Even if you believe that the rating have been entirely wrong on the analytics side of their CLO ratings – and this is a hard claim to make for this asset class – they provide the investor with an additional set of eyes on the deal terms. While there are and will always remain certain loopholes and ambiguities (see for example the TPG issue in TruPS CDO world here), one can only imagine how many more difficulties would have arisen if it weren’t for the trained eye of the rating analysts.


Firstly, having rating agencies analyze the documents heightens the consistency across documents, and decreases the likelihood that your bond won’t have this minor helpful nuance that was introduced by the rating agencies for other bonds. Consistency is good – it helps subsequent potential investors compare apples to apples. This improves, among other things, the ability to value your security and, probably, the value of the security itself as complexities drive prices lower.

In tandem with consistency comes liquidity. The more similar your security to others that are traded, the less security-specific work any bidder would have to do on yours, which drives up the price.

But more importantly, certain funds and companies may still require or prefer ratings in the future on all purchased securities. If your security’s not rated, you’ll have a smaller set of bidders. Less demand, lower price.

Moral of the Blog: it’s not advisable to hop off the ratings wagon, especially for complex, already-illiquid securities such as CLOs, where the rating agencies provide a tangible service to the investor. Separately, we need to continue our efforts towards restoring investor confidence in ratings integrity as soon as possible.

Monday, October 12, 2009

Anatomy of a Recovery

A quick update on the rock star world of corporate loans after a bumper first three quarters of 2009…

Leveraged loans have now rallied for 9 consecutive months on the back of a perceived general economic recovery – or lower probability of total collapse - and the heightened availability of refinancing and loan modification options for the borrowers.

Having been battered throughout 2008, the first quarter of '09 kicked off with the recovery of the higher quality leveraged loans (generally the BBs). Since then, it’s all been about the lower quality loans (the single Bs and the CCCs) whose performance now far exceeds that of the BBs for 2009:
- the BBs, Bs, and CCCs have year-to-date total returns of 34.2%, 55.0% and 76.4% respectively, according to S&P’s LCD Loan Index as of October 9.

A second change in dynamics has been the evolution of loan refinancings, a trend we’ll continue to watch as a ton of loans are set to mature in the coming three years. Whereas in Q1 ’09 we saw borrowers trying to raise capital to buy back maturing loans, they’re now increasingly seeking to extend the maturities of those loans, often in exchange for a minor amendment fee and an increased spread on the loan or facility. (You can read more about the “amend-to-extend” pattern here.)

While loan covenant relief has staved off certain impending defaults, the rating agencies generally see default rates continuing to rise from their current peaks around 10% for these speculative-grade issuers, tailoring off towards year end or at latest mid-2010. (Note that while refinancing opportunities – in particular debt extension – are typically a net positive for both the borrower and the lender, it does little from the rating agency’s perspective, as they focus on the borrower's ability to meet its net outstanding debt payments, irrespective of their form.)

Moving into 2010 and 2011, growth and recovery remain key for this asset class: covenant amendments, while decreasing short-term default probability, often also restrict borrower purchases in exchange for allowing lower coverage ratios. Lower coverage ratios augur poorly for eventual defaults, if and when they do happen; and the purchasing restrictions, coupled with the more expensive debt coupon, may stymie growth potential.