The FINANCIAL — London-10 October 2011: Fitch Ratings says that European leveraged loan collateralised loan obligations (CLOs) are likely to come under increasing pressure in Q411.
The agency's newly-published October 2011 European Leveraged Loan CLO Tracker (CLO Tracker) reveals that the 'CCC' bucket has increased to 8.7% from 7.4% in January 2011. As of the June 2011 CLO Tracker, there were no new recorded defaults of any leveraged loans referenced in Fitch-rated CLOs. This has since changed, with two new defaults recorded in Q311. The average 'AAA' over-collateralisation (OC) test cushion, excluding Melepard CDO 1 Limited, which has experienced a large prepayment (37%) of its senior note in the last quarter, is 10.58% which is virtually unchanged from 10.55% in June 2011. These trends indicate that it will be difficult for CLOs to maintain the performance improvement experienced over the past year.
The agency notes that there is a time lag between the data reported in the investor reports and current market conditions. Current macroeconomic conditions have dented the gains European leveraged loan prices have made over the past year. According to Markit, a loan pricing provider, the average European loan bid in the secondary market increased to a high of 93 in March 2011 from a price of 87 in November 2010, before falling back down to 87 in Q311. Fitch expects CLOs' OC tests to come under increasing pressure if the underlying leveraged loans' negative rating migration gathers pace combined with volatile and falling leveraged loan prices.
Fitch observes that structural features have helped the average CLO perform largely as expected with excess spread providing support to the senior rated notes. For instance, an increase in the 'CCC' bucket or defaulted assets could be mitigated by the breaching of OC tests, which diverts excess spread for reinvestment or to redeem the senior rated notes. Nevertheless, CLOs remain susceptible to a clustering of defaults due to the approaching refinancing wall and lower than expected recoveries, as evidenced by the Negative Outlooks Fitch has assigned to the majority of the Fitch-rated CLOs mezzanine and junior notes.
Fitch's October 2011 CLO Tracker includes additional information, i.e. CLO notes' spread/coupon, type of reinvestment allowed after reinvestment period and equity noteholders call option, which could help investors analyse the likelihood of CLOs continuing to fund the wider European leveraged loan market in light of concerns about the upcoming refinancing wall.
The vast majority of pre-crisis CLOs allow the reinvestment of certain proceeds such as unscheduled principal proceeds past the reinvestment period. This is subject to certain conditions being met e.g. portfolio profile and coverage tests must be maintained or improved, or the CLO notes have not been downgraded below their original ratings. There is an end date to the reinvestment of these unscheduled proceeds for the Harbourmaster CLO transactions. Fitch believes this provides flexibility to CLO managers to continue reinvesting past the 2013-2014 refinancing wall, but the flexibility would decrease with the passage of time if reinvestment is subject to a maximum weighted average life test or as market conditions worsen and tests start to be breached.
Equity noteholders usually have the option to call the CLO just before the reinvestment end date when the cost of funding would become less favourable to the equity noteholders as the senior less-costly notes start to delever. A deal can typically be called only if expected proceeds from portfolio liquidation are sufficient to repay all notes ranked above the equity notes at par. The non-call period, after which equity noteholders can exercise the call option, ends on average 4.5 years after the deal closes amongst Fitch-rated CLOs. The non-call period has ended for 16 of the 28 Fitch-rated CLOs and it will expire for a further 11 CLOs within the next 12 months. In Fitch's view, the likelihood of a deal being called depends on both the ability and the willingness of the equity noteholders to call the deal. While the willingness of equity noteholders to call a deal would depend in part on their targeted internal rate of return, Fitch believes the ability of equity noteholders to call a deal is limited in the current market environment of falling loan prices.
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