The share of new-issue collateralized loan obligations rated by Moody's fell to multiyear lows in both the U.S. and Europe in 2020, according to LCD data.

The drop was more pronounced in the U.S., where Moody's share of CLO ratings by deal count fell from 60% in 2019, to 23% in 2020 (as of Dec. 14), whereas in Europe its share fell from 75% in 2019 to 52% this year.

Moody's market share peaked in 2018 in Europe, when 100% of new issue CLOs contained a rating by Moody's. The peak for U.S. deals was in 2015, when 93% of new CLOs contained a Moody's rating, according to LCD data.

This loss of market share preceded Moody's changing its methodology for rating CLOs, announced Dec. 7, that could lead to large improvements in WARF — the weighted average rating factor, which indicates the default probability of a CLO's collateral assets — but it may take time to filter through, according to analysts.

On Dec. 7, Moody's published its updated methodology for rating CLOs, for which the key change is related to the treatment of assets in a CLO that have a negative outlook or whose ratings are on review for downgrade.

As part of the updated methodology, for the purpose of assessing an obligor's Moody's Default Probability Rating, assets on review for downgrade will now be adjusted down by one notch, versus two previously. In addition, there will now be no adjustments for assets that have been assigned a negative outlook, whereas previously they were adjusted down by one notch.

In a press release published Dec. 7, Moody's wrote that it expected the change to result in a generally positive impact on ratings, largely comprising reviews for possible upgrade and single-notch upgrades totaling around 5% of the approximately 7,000 outstanding rated CLO tranches in the U.S. and the EMEA (Europe, the Middle East and Africa) region.

Following the announcement, Moody's on Dec. 8 disclosed that it had upgraded the ratings on 23 CLO notes issued by 11 European CLOs and had placed 117 notes from 44 European CLOs on review for possible upgrade. On the same day, Moody's placed the ratings on 188 CLO notes from 114 U.S. CLOs on review for possible upgrade.

A significant majority of the securities placed on review for possible upgrade are from CLOs in, or entering, their amortization periods, Moody's noted.

The most significant and longer-term effect of the update is expected to be the change in the method for how new CLOs calculate and report WARFs for collateral quality tests.

"Based on the updated methodology, we estimate WARF levels could improve by around 250 points for an average CLO should the change be implemented" analysts at BofA Securities wrote in a Dec. 9 research note.

Analysts at Barclays estimate that for existing deals that are able to amend WARF calculations, WARF score improvements of nearly 10%, or more than 300 points, could be made, which analysts noted would put median WARF levels back to pre-COVID-19 levels in the U.S. and Europe.

"This potential drastic improvement in WARFs is due to most negative ratings (primarily negative outlooks) in the U.S. and European loan markets being on lower-quality, more COVID-exposed names" Barclays' analysts wrote in a Dec. 11 report. "So for CLOs that incorporate the new language and allow WARF tests to pass again, thus releasing the requirement to "maintain or improve" portfolio quality on new trades, we think the 34-35% of B3 loans on negative outlook in each market could become attractive."

Similarly, analysts at BofA Securities predict an improved marginal demand from new issue CLOs for CFR B2 loans on negative watch and/or CFR B3 loans with a negative outlook. "Additionally, future adverse rating agency actions (neg watch/outlook) on loans may not result in significant price declines vs. in the past," the BofA analysts wrote.

But while some effects from the update have been more immediate, analysts expect wider proliferation to take time to filter through the market.

"For currently outstanding deals, we think an amendment of deal documents to allow for the new calculation would require a mix of a rating agency confirmation along with potential AAA consent, which may be difficult to win over," Barclays noted. "New issue and reset deals that incorporate a Moody's WARF test, though, are likely to include the new language. As a result, the proliferation of the new WARF calculation in the CLO market may take time, potentially leading to a wide dispersion in reported WARFs."