The Importance of Being Investment Grade

While references to credit ratings are being removed from statutes and federal regulations (effective July 2012) their position in our existing investment framework remains secure.

We have discussed previously how credit rating downgrades might negatively influence a security's price by decreasing investor demand (some funds and companies, for example, can only buy debt of a certain credit quality) and increasing funding costs (collateral/margin requirements), which may lead to the inevitable vicious cycle.

The deeply embedded nature of ratings in financial contracts is even more apparent when we look at the ramifications of a downgrade on H&R Block's corporate debt (CUSIP 093662AD6), which has been the recent focus of negative attention from the rating agencies. If the debt is downgraded by Moody's to Ba1 or below and/or by S&P to BB+ or below, the coupon on these notes will increase, and the debt will thereby become more expensive to HRB. In other words, if a downgrade is an indication that a company is struggling to meet its obligations, the downgrade in its enactment (by construction) might make said obligations more expensive, which precipitates further difficulty in meeting them. As such, the rating provided is integral to, and certainly not de-linked from, the performance of the security being rated.

These bonds are currently Baa or BBB, investment-grade bonds. However, as the table illustrates, if either rating agency alone downgrades the debt to the Ba1 or BB+ level, the coupon on the bond will increase by 25bps from 7.875% to 8.125%. If both rating agencies downgrade the debt to this level, the result will be a 50bps increase to 8.375%. The interest rate increase is capped at 2%, which will be effectuated if Moody's downgrades the bond to B1 or below and S&P downgrades it to B+ or below.

The (unfortunate) consequence: a downgrade immediately increases the coupon on the bond, which decreases the price. That's in addition to the decreased demand for the bond, the heightened illiquidity, and the increased funding costs for holding the bond. If downgraded, a devaluation of the bond is inevitable, irrespective of the market's opinion of the accuracy of the rating agencies' opinions.

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.

The CLO Also Rises

The May/June rally and subsequent stabilization of CLO tranche values has shown us that despite times of deep distress, culminating in loan downgrades and defaults, CLO managers on average have been at least temporarily able to build OC coverage. In sum, the par they were able to gain by way of their discount purchases, together with loan price appreciation and the ability to offload certain CCC assets, served as a greater combined force than the dual impositions of portfolio downgrades and defaults.

But one other item has become more readily apparent since May: that investors are increasingly differentiating between AAA CLO tranches (or, at least, between what were originally AAA CLO tranches), resulting in their trading within a wider bracket. As we shall see, not all AAA CLO tranches were created equal.

The complexities in evaluating CLOs, or even CDOs in general, are not limited to making long-term assumptions on a potentially dynamic, managed pool. Nor are the complexities limited to the modeling of each deal’s intricate structural features, such as pro-rata sequential paydowns or BBB tranche turbo features. The language of the indenture – the CLO’s governing document – brings with it a host of nuances in interpretation.

Our most recent piece explores one of the more timely nuances: the varying natures of CCC-rated loan haircuts.

The full report can be read here: Special Report: CLO CCC Buckets - Key Variations in Terms and Performance

An excerpt from the piece:

"... an investor looking for exposure to a CLO that does not have aggressive deleveraging provisions would want a CCC bucket has some or all of the following features:

- is as large as possible (at least 10%);

- references Moody’s loan rating not CFR in determining which securities are in the CCC bucket (and that has as “flexible” a definition of Moody’s rating as possible);

- includes only purchased CCC securities in the CCC bucket;

- haircuts excess CCC securities to MV (with as “flexible” a MV definition as possible);

- is ambiguous on which securities fill the bucket first (or even allows low MV securities to fill first); and,

- diverts cash‐flow for reinvestment and never for deleveraging.

In contrast, an investor looking for exposure to a CLO that has aggressive deleveraging provisions would want a CCC bucket that has all of the following features:

- is as small as possible (no more than 2.5%);

- references Moody’s CFR and not Moody’s loan rating in determining which securities are in the CCC bucket (and that has an “unambiguous” definition of Moody’s rating);

- includes all CCC securities (including both purchased and downgraded CCCs) in the CCC bucket;

- treats excess CCC securities the same as Defaulted Securities and haircuts them to the lesser of MV and recover value (and that has a strict definition of MV);

- clearly fills the CCC bucket with only the highest MV securities first; and,

- diverts cash‐flow for deleveraging only and not for reinvestment."

The KYSS Principle

We're coining a new phrase on this bright-n-sunny summer morning:

KYSS - Know Your Super Senior

Or Know Your Senior Secured. Either way, knowing who's above you in the capital structure can be immensely useful, particularly in the world of defaults.

We've been seeing this in ABS CDO space for a while now, as the contrasting interests and demands of the controlling class holders have determined whether defaulting CDOs were liquidated or accelerated.

And we recently spoke about this in the leveraged loan world too (click here for the full transcript) where banks and CLO managers have possibly different agendas in the corporate loan amendment process:

The big difference is when banks are the lenders the relationship between the borrower and the lender often goes back many, many years and may include businesses like bond underwriting and cash management and other types of solutions that the banks offer. And so the banks are going to be even more incentivized than usual to grant covenant relief and find a solution that allows for continued revenue generation. With institutional investors, on the other hand—and we’re talking CLOs, prime rate mutual funds and the like— they’re “transactional lenders.” In other words, their relationship doesn’t go any further back than the individual loan in question here and so their incentives will be naturally more immediately self‐serving.

Thus, as a prospective subordinated bondholder (i.e., purchaser) it might be wise to find out who is holding the senior secured loan. What would the amendment process look like? What sort of acquisition restrictions will be imposed on the borrower post amendment, and amendment fees and charges will leak to the senior lender. (See for example Richard Kellerhals' recent piece Investors Fume as Banks “Extend and Pretend.”)

So go ahead and KYSS - it may even change the way you see the bond you currently hold.

Impact of amendments on CLOs

Your good friend GP was recently interviewed on the state of corporate loans and CLOs amid the flurry of credit agreement amendments.

You can download the full podcast here.

Is your CDO Leaking

CDO noteholders, pay close attention to your monthly trustee reports. These are complicated deals and trustees make mistakes. Most of the time, these mistakes cost you nothing but every now and then they'll cost you millions.

For example, a mistake we picked up today revolves around an incorrect implementation of the “CCC Haircut Amount.” It's responsible for leaking approximately $4 million to equity when that amount should have been used to pay down senior notes.

The details...

Here's the definition from the O.M :

Click to enlarge

In simpler words, if this CDO has too many poorly rated assets then it has to carry a portion of these (“The Excess”) at market value (vs. par) when computing the numerator of this CDO’s overcollateralization tests. (The ensuing lower numerator increases the likelihood of an overcollateralization test trip. If such a trip occurs, cashflows that would have otherwise gone to subordinated tranches are redirected to pay down more senior tranches.)

Additionally, the definition specifies that The Excess should consist of those poorly rated assets with the lowest market values (this is typical) but the trustee made a mistake and picked the ones with the highest…

WHAT HAPPENED / WHAT SHOULD HAVE HAPPENED?

Click to enlarge

This misapplication of the CCC Haircut Amount definition causes the class D overcollateralization test to pass when it should in fact fail. Because this test passes, cashflows are leaked out of the deal to equity when they should have been used to pay down the senior tranches in an effort to cure the failing test.

While this is the first distribution date during which the impact of this mistake is felt, chances are that the trustee will keep making it moving forward, ultimately sticking millions in losses to the wrong group of noteholders.

Here are the details of the CCC Haircut Amount calc.:

Click to enlarge

We’ve got a handful of these examples; we’ll try writing more of these in the future if there is an interest…

Hedge Funds and Rabid Regulation

With Obama urging Congress to empower regulatory units and quicken regulation, one is encouraged to ponder on philosophically.

Are we simply overcompensating for having been under-regulated or poorly regulated? Are we ready to impose and adopt new regulation? Is regulation even a cure?

As one can imagine, poor regulation in its abundance may have a similarly negative effect to poor regulation in its absence. Perhaps there's a covenient middle ground. But the speedy (raging) imposition of new regulation simply cannot be the answer: it hinders growth and poses significant operational burden at a time when the U.S. -- no, world -- economy simply cannot support it. And it's expensive.

Now we don't contend that all regulation is bad. Some of it, for example the rating agency debate, is healthy. But when the political maneuvering becomes extreme it can undo much of the good work that came before it. Hedge funds, for example, are appealing due to the leverage and return they can achieve. But they become infeasible under certain regulatory and disclosure regimes. We are, in effect, ensuring that very few hedge funds can and would want to continue existing. The move towads being an asset manager, consulting firm, or bank would be much more appealing: if you're going to be heavily regulated anyway, why not take the upside?

The hedge fund industry certainly has a few items worthy of an additional eye (i.e., some form of supervision). We've spoken a little about sidepockets and challenges in consistently presenting fair value. Side letters, as an aside, and redemption gates are also obviously problematic and requiring attention.

And so too are fund documents: not only the restrictions they impose, but more importantly the capabilities and flexibilities their language allows. As Risk Without Reward (RWR) points out, the idea of "buyer beware" is only useful if the documents have not been drafted in such a way that allows just about anything "in the sole discretion of the investment manager."

For example, CDO indentures for managed deals have various sections describing what are acceptable Substitute Collateral Debt Securities. Fund documents, less so.(Even today we saw -- and it's not necessarily a bad thing -- two of Eaton Vance's funds approving investment in alternative new asset classes, with one fund allowing investments in commercial mortgage-backed securities (CMBS) and the short-selling of sovereign bonds subject to certain limits. For another way managers get around regulation see Regulatory Capital Arbitrage.)

Aside from investment criteria investors should look at operating expenses for the fund. Does the hedge fund pass legal and formation fees onto the fund owners? Okay. Are investors alone paying for data and vendor tools that are used for the manager's other (possibly prop capital) funds? Is that sharing pro-rata? And is the fund paying for the marketing of its shares? (Hat tip to RWR for this catch). Data and analytical tools are expensive, as can be the fund marketer's traveling expenses. Frustrating indeed. But time to ask those tough questions. While we still have hedge funds.

The Corporate Loan Conundrum

Here's our two cents worth on the year-end state of the leveraged loan market, and a little insight into the challenges that lie ahead.

First off, 2008 was a tough year for corporate loans. Among leveraged loans, we saw roughly 4.5% to 5% defaults for the year, heavy pricing declines (the S&P/LSTA U.S. Leveraged Loan 100 Index was down roughly 30% in '08) and with them low recoveries, due, among other things, to the supply/demand problem and pessimistic perceptions for the economy.

(Worth pointing out was a slight uptick in the second half of December. Was this a bottoming out? A false bottom perhaps? Some high-level executives and managers are vocal about current spread levels being at or near their highs, and that we're due for some tightening in 2009. See for example Creditflux's Viewpoint: Looking for the bottom; but are they talking their book, and do we really have a good feeling for the duration of loans in this low, slow prepayment environment?)

An Issue of SUPPLY (and demand)

Demand is so small is deserves only a side mention; supply is the elephant. Why?

1. Fund (incl. hedge fund) liquidations and forced selling, to meet both investor redemption requests and (particularly variation) margin calls
2. Selling by banks to decrease leverage
3. Overhang of unsold loans (incl. bridge loans) on syndication desks' balance sheets that the banks were no longer able to securitize due to the severely diminished CLO juggernaut, a previously major source of demand for broadly syndicated loans
4. Demand by existing CLO managers has decreased too:

• low prepayments on current loans in the portfolio mean less available principal to reinvest
• loan downgrades have resulted in many CLOs maxing out on their CCC-rated buckets (which in turn limits managerial flexibility in trading new loans)
• historically low loan prices mean that investments in these loans are reflected as "deep discount" purchases for overcollateralization test purposes

What the future holds for loans and CLOs

Corporate loans weren't highly traded, relative to bonds, say, prior to the onslaught of CLOs (which steadily gained steam from 2001 to early 2007). S&P/Markit/Reuters' move towards a CUSIP identifier (from LoanX, LN numbers) may prove of minor assistance to the liquidity situation, but this will take a while.

The prospects are dim for 2009: large supply and high defaults are typically accompanied by low recoveries, a dual burden (see for example Longstaff, Schwarz's "A Simple Approach to Valuing Risky Fixed and Floating Rate Debt").

As this relates to CLOs: as defaults continue to plague corporations and deals continue to fill their CCC buckets -- and then have excess CCC assets haircut at market value (not recovery rate) for overcollateralization test purposes -- more CLOs naturally begin to trip overcollateralization triggers on a weekly basis, causing cashflows to be directed from the junior tranches and residual pieces towards paying down senior note holders (reducing the duration of the latter).

Similarly detrimental is the fact that most CLOs ramped up their loan portfolios during a credit cycle marked by the particularly high levels of liquidity it generated and the low defaults exhibited. The resulting strong demand created the opportunity for debt issuers to obtain low coupons on their debt despite weak covenant packages. Strong covenant packages typically reduce a company's cost of debt and, importantly, protect debt investors from wide negative swings in the value of their investment. (In sum, relative to a company's overall investors, weak debt covenants are arguably equity-friendly for the company, and debt-unfriendly.) See also The Luxuries of a Covenant Light Lifestyle.

The optimistic view is that this can all change quickly if we begin to see sufficient buyer power at these distressed levels. If some of the distressed funds decide that the opportunities lie in loans, and the bigger loan/asset managers (PIMCO, Babson, TCW, Blackrock) start putting their money to work, loan prices could rebound even on thin volumes and the deals which have benefitted from decent excess spread generation over the last 4 to 5 years during the low default environment may survive some of the pending difficulties. Certainly we're optimistic that many, if not most, of the AAA tranches will come out whole in this scenario, but whether the AA or single A tranches survive or suffer principal losses may differ from deal to deal, and may depend on the remaining length of each deal's reinvestment period, among other things.

While we fear the worst, we're long optimism.

The Luxuries of a Covenant Light Lifestyle

Blackstone president and COO Tony James wrote a piece for the Financial Times this morning touting covenant light loans as a "positive development," allowing companies "the flexibility to work through their problems and, thus, help maximise total enterprise value."

When a business hits a downturn, because of either poor management or external forces, you want the business to continue. An ongoing business has a far greater total enterprise value than one liquidating. Loans with strict covenants can destabilise an otherwise healthy company, when even a short recession over a few quarters might trigger defaults. The holders of the senior debt take action; cash flow stops to the junior debt, suppliers stop shipping, customers flee and employees lose jobs. The equity holders with little or no remaining stake in the business not only find it difficult to restore health to the business, but they have no economic incentive to do so.

Equally important is the value destruction that ensues when a company defaults. Creditors squabble and courts hold interminable hearings. In the meantime, the company drifts. The very worst time for a boat to lose its pilot is during a storm. But this is exactly what results from the traditional hair-trigger covenants that many see as the healthy formulation of leveraged capital structures.

All valid points, perhaps. But let's dig a little deeper...

Typically, the two pertinent loan covenants are incurrence and maintenance covenants. Incurrence covenants restrict the company's ability to issue debt (typically, senior to this loan - which makes sense, especially if you're the lender and wish to retain your level of seniority). Maintenance covenants describe (minimum) collateralization levels (think coverage ratios) that must be maintained to avoid the loan from being in default. When you speak of covenant light loans, you're primarily talking about loans who lack the maintenance covenant(s). The fewer the covenants, the lower the likelihood of default, and hence Mr. James' rosy article.

Now let's consider covenant light loans as a microcosm for today's environment. Everybody's long regulation. Regulation is king. The market has seen what happens without it, and decided that it prefers regulation. Let's examine the lack of restriction (as a metaphor for regulation) on covenant light loans. The covenants act as a means for the lender to involve itself (think govern or regulate) in the performance of the company if/when it fails to comply with its covenants. Among other things, the lender can extract additional spread from the failing company (as an alternative to enforcing default) or, upon default, the lender at least has a strong position at the negotiation table, as a senior secured lender, and since the only-recently-failing maintenance coverage ratio describes the company's ability to "cover" the loan, the lender often walks away whole, or at least close to whole.

In the absence of such a covenant, the lender has limited recourse until default. Granted that defaults are less likely, but once they occur, who is to say what the recovery rate may be?

In summary, if I'm borrowing, I'm long the additional flexibility (unless it costs much more); but as a lender, one has to expect that the severity of any defaults will be sharply higher than those having quality/coverage controls in place. This is the real downside that should be guarded against: lenders with large exposure to low-recourse, low-recovery loans which are or may defer interest or "pay-in-kind."