Standard & Poor’s is altering its approach to grading corporate loans after lagging behind the competition in one of the fastest growing parts of the debt market.
Changes by the world’s biggest credit-rating firm would, in effect, increase the estimates for how much lenders in some loans will get back in the event of a default, allowing investment firms to bundle riskier, higher-yielding debt into collateralized loan obligations. S&P’s share of the grades assigned to the biggest portion of CLOs declined over the last six quarters, to 57 percent from 100 percent, according to Wells Fargo & Co.
CLOs are booming, with JPMorgan Chase & Co. and Wells Fargo saying as much as $100 billion will be raised this year in the U.S., surpassing the record $93 billion in 2007. CLOs are the biggest buyers of leveraged loans, which the Federal Reserve and the Office of the Comptroller of the Currency identified as an area of concern due to deteriorating underwriting standards.
“It seems likely that the changes will be viewed by the market as helpful,” Rupert Wall, a structured finance partner at law firm Weil, Gotshal & Manges LLP in London, said yesterday in a telephone interview.
CLOs pool high-yield corporate loans and slice them into securities of varying risk and return, typically from AAA ratings down to B. Last quarter, they bought 63 percent of loans in the U.S., according to the Loan Syndications and Trading Association, which cited S&P’s Capital IQ Leveraged Commentary and Data.
Moody’s Investors Service, the second-biggest credit grader, rated 85 percent of the least-risky CLO slices in the second quarter, according to Wells Fargo. Fitch Ratings boosted its share to 43 percent from 14 percent in the first three months of the year.
Some $82.1 billion of CLOs have been raised in the U.S. this year, compared with $87.1 billion in all of 2013, according to JPMorgan. The growth is helping fuel demand for high-yield loans, with new debt sales of about $270 billion this year after record issuance of $359 billion in all of 2013, Bloomberg data show.
The bull market for loans has continued after the Fed, OCC and Federal Deposit Insurance Corp. in March 2013 updated leveraged-lending guidance, saying debt levels of more than six times earnings before interest, taxes, depreciation and amortization “raises concerns.” Underwriting should also consider a borrower’s ability to pay down debt to a sustainable level within a “reasonable period,” they said.
Managers typically need grades from at least two ratings firms for the most senior portion of a CLO and one for each of the lower-ranked slices.
S&P ranks loan recoveries on a scale from one to six. A grade of two, for example, indicates a 70 percent to 90 percent recovery of principal for creditors in the event a borrower defaults. New York-based S&P said under the updated methodology, which was announced July 18, it will be more exact, saying whether it expects recoveries to fall into a lower or higher range.
For a level two rating, that would specify whether the loan is in the 70 to 80 percent range or a higher 80 to 90 percent zone.
More than 48 percent of loans with a recovery rating of two fell into the higher end and more than 53 percent with a grade of three fell into the top ranking, according to an Aug. 18 report from S&P. The updated information is then incorporated into S&P’s CLO criteria, according to an Aug. 1 report.
“It’s all a matter of transparency and investor need,” Andrew Watt, a managing director at S&P, said in a telephone interview yesterday. “We have been working through this for the better part of a few months; it fits in with the overall strategy for providing transparency. The change is relatively modest from our perspective.”
Anthony Mirenda, a Moody’s spokesman, declined to comment on its market share. Daniel Noonan, a spokesman for Fitch, said in an e-mail that the firm “has taken a disciplined approach to rating CLOs over many years.”
By tweaking its recovery ratings, S&P is tackling part of its methodolgy that has left it at a disadvantage to rival Moody’s, which doesn’t use the same measure, according to Preston.
CLO managers found S&P’s old methodology “constraining” because they were sometimes forced to choose loans for their deals purely to stay in compliance with the recovery tests, he said. “Managers didn’t like it driving their credit decisions.”
The revisions may be an attempt to win more business from CLO managers, according to Janet Tavakoli, the founder of Chicago-based consulting firm Tavakoli Structured Finance Inc.
“This looks like an irresponsible grab for market share,” Tavakoli, who traded, structured and sold derivatives for over more than two decades in the financial industry, said yesterday in a telephone interview.
Credit rating firms will face new restrictions on conflicts of interest under rules set to be adopted by the U.S. Securities and Exchange Commission. They will have to ensure they follow internal methodologies when grading debt and revising ratings under rules commissioners will consider at a meeting in Washington today.
Analytic independence is a core principle of S&P’s rating process and represents a long-held policy separating analytic and commercial activities at the firm, April Kabahar, an S&P spokeswoman, said in an e-mailed statement.
While the methodology change by S&P may boost the recovery value assigned to some loans, maintaining a CLO is a “balancing act” because they must comply with different tests that also measure loan spreads and credit ratings, Dave Preston, an analyst at Wells Fargo in Charlotte, North Carolina, said yesterday in a telephone interview.
While managers may decide not to use S&P grades, Preston wrote in a report to clients that there is a tradeoff for choosing another firm. Moody’s reduced the ratings on more BBB and BB rated portions of CLOs than its peers, according to Preston.
“There have always been periods when particular agencies have been out of favor because of specifics of their criteria and methodology,” said Wall at Weil Gotshal. “Neither arrangers nor managers are wedded to a particular agency. They will choose the most helpful at the time for a particular deal.”