Friday, April 22, 2011

Ratings Reversals

Back in our December 2010 piece (The Psychological Biases of Holding Downgraded Bonds) we commented on what was to us a rather unusual trend in the collateralize loan obligation space, where these bonds were being downgraded at a time when their fundamentals were already (generally) rebounding.

“[One] rating agency began downgrading collateralized loan obligation (CLO)securities between September 2009 and May 2010, well after the market shock had ended, with loan prices generally having begun returning to 'normal' levels in December 2008. Depending on what indices you examine, loan prices generally went up roughly 40% during calendar year 2009, and this trend has continued in 2010. CLO prices improved too, as have their underlying portfolios. So while the rating agency was aggressively downgrading almost 3,000 bonds during this time period, the underlying loan market and the CLOs themselves were markedly improving.”
Moody’s recently produced some very informative data on their ratings reversal rates in structured finance. Not surprisingly – at least to to us and the avid readers of our blog – CLOs lead the list of ratings reversals, at a rate of approximately 5 times that of other CDOs (excluding CLOs) and more than 6 times the rate of all global structured finance ratings provided by Moody’s.

The downgrading (if it is premature) of a long-term bond only to subsequently upgrade it falls broadly within what is referred to as a “Type II” ratings error.

Holding lower-rated bonds can be more expensive for investors. This may encourage holders to sell the bonds to the extent the cost of funding the lower-rated bonds is too high, or they may even become forced sellers to the extent the lower ratings fall outside of their investment guidelines or their vehicles’ eligibility criteria. Thus, in addition to the (rather unfortunate) increased cost of funding on a downgraded bond, one may be forced to sell the bond at an inopportune time, only to see the bond subsequently re-upgraded.

Ratings reversals can include downgrades followed soon after by upgrades, or upgrades accompanied by subsequent downgrades.

Examples of Moody’s ratings reversals:

1 - Gresham Street CDO Funding 2003 class B notes (CUSIP 39777PAB9): Originally rated Aaa in 2003. Downgraded (Moody’s) to A1 in Aug. 2009. Upgraded to Aaa in May 2010. (S&P maintained rating at AAA throughout.)

2 - Halcyon Loan Investors tranche B (CUSIP 40536YAJ3): Downgraded from A2 to Ba1 (March ’09) to B3 (June ‘09); upgraded back to Ba3 (May ’10) and Ba1 (Dec. ’10).

Happy Easter everybody!
- PF2

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