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CLO Interest Summary - April 2018

Core Content

This report from Moody's CLO/Structured Credit Group discusses the evolving landscape of Collateralized Loan Obligations (CLOs), particularly focusing on the weakening of documentation constraints and its implications for credit quality and risk exposure. It highlights how these changes are influenced by market dynamics and the broader trend of covenant-lite (cov-lite) loans.

Main Points

1. Weakening of CLO Documentation Constraints

• Trend Overview: Constraints in CLO documentation are weakening, similar to the trend seen in the proliferation of cov-lite loans.
• Drivers: Low interest rates and robust financial market valuations have encouraged investors to accept more risk or pursue higher returns.
• Impact: Loosened constraints increase the potential for CLOs to drift toward lower credit quality or erode structural protections, thus increasing vulnerability to certain economic or market scenarios.

2. Key Changes to Collateral Quality Tests

• Distorted Metrics: CLOs are increasingly distorting collateral quality tests such as WAL, WARF, WAS, and WARR.
• WAS Adjustments: Some CLOs allow overstatement of WAS by using purchase prices instead of market values, which can lead to increased credit risk if not offset by other measures.
• WAL and WARF: CLOs are more flexible in defining WAL and WARF, which can allow the exclusion of lower-quality assets and increase the risk of underperformance.

3. Weakened Collateral Composition Constraints

• Credit Risk Exchanges: CLOs are more frequently allowing the exchange of credit risk assets, bypassing some collateral quality tests.
• Cov-lite Loans: CLOs are increasingly including cov-lite loans, which lack financial maintenance covenants.
• Maturity Extensions: CLOs are allowing assets to mature beyond the legal maturity of the notes or to extend maturities with fewer restrictions.
• DDO Substitutions: More flexibility is being given to substitute deep-discount obligations (DDO) with other assets.

4. Structural Changes to Facilitate Par Erosion

• Trading Gains as Interest: CLOs are treating trading gains as interest proceeds, which can reduce reinvestment and amortization of notes.
• Excess Principal Recharacterization: Some CLOs allow excess principal proceeds to be recharacterized as interest, further reducing reinvestment opportunities.
• Time-Based Target Par Thresholds: More CLOs are using target par thresholds that decrease over time, making par erosion more likely.

5. Flexibility in Document Amendments

• Limited Noteholder Involvement: CLOs increasingly allow amendments to their governing documents with limited noteholder approval.
• Common Amendments: These include changes to rating methodologies, collateral quality test definitions, and trading rules.
• Risk Mitigation: While some amendments increase credit risk, others provide structural flexibility that can be used to improve credit performance.

6. Structural Advantages of CLO 2.0s

• Higher Subordination Levels: CLO 2.0s typically have higher tranche subordination levels than CLO 1.0s.
• Shorter Reinvestment Periods: CLO 2.0s have shorter reinvestment periods, limiting the opportunity for credit erosion through trading.
• Exclusion of Structured Finance: CLO 2.0s generally exclude structured finance instruments and synthetic securities.

Key Performance Indicators (January 2018)

Summary of March 2018 Surveillance Update

• Upgrades: Ratings were upgraded on various tranches across both US and European CLOs, primarily due to deleveraging and increased overcollateralization (OC) ratios.
• Downgrades: Some tranches were downgraded due to credit deterioration and covenant breaches.
• Withdrawals: Ratings were withdrawn for tranches that were refinanced, reset, or paid in full.

Conclusion

The weakening of CLO documentation constraints, especially in the context of the broader trend of cov-lite loans, has introduced new risks for noteholders. While some of these changes offer flexibility to managers, they also pose challenges to credit quality and structural protections. CLO 2.0s still retain important structural advantages over CLO 1.0s, including higher subordination levels and shorter reinvestment periods, which help mitigate some of the credit risks. The report underscores the importance of understanding the nuances of each CLO's documentation and structure in assessing credit risk.