Collateralized loan obligations (CLOs) are structured vehicles that portfolio managers create using securitization techniques to issue notes (i.e., tranches) to investors. A tranche's characteristics (size, coupon, credit support, etc.) are determined based both on the investors' requirements and on the issuer's objectives. As such, tranches within a single CLO transaction can have different S&P Global Ratings' credit ratings assigned to them at the closing date, and at any point during the transaction's life, depending on their subordination and the collateral that backs them.

The collateral backing a CLO transaction, or "portfolio," is predominantly senior secured loans made to a diverse set of borrowers from different industries. The CLO tranches rely on the payments from these underlying loans to receive their payments due on interest and principal. Based on the performance of the underlying loans during our surveillance of the transaction, the ratings on some tranches in a CLO may not move in the same direction as others; in some situations, our rating actions on a transaction might involve upgrades for the senior notes and simultaneous downgrades of the junior notes.

We are publishing this Credit FAQ to provide more information about this possible situation.

Frequently Asked Questions

How can there be upgrades and downgrades at the same time in a CLO? If backed by the same credits, shouldn't they bear the same risk?

Though the same portfolio backs all of the tranches of a CLO equally, there can be circumstances where the ratings assignments on different tranches may move in opposite directions during the life of the transaction depending on how that portfolio's support changes, which may affect each tranche's risk profile differently.

The answer to this question really goes into the heart of what securitization is and one of the prime benefits of structured finance. Given the ability to receive the payments first even though all noteholders rely on the same portfolio, the senior noteholders may be in a more secure position than other noteholders (and equityholders) beneath them in priority. As a result of the tiered priority, if there are losses in the portfolio, the equityholders would be affected first (by a corresponding loss in their ultimate distribution), then the junior noteholders, and then the senior noteholders only later.

Reversely, deleveraging would benefit the senior noteholders first and would not affect the junior and equity noteholders until later.

So, even though the portfolio backing the notes is the same, the ultimate risk borne by the various noteholders are different.

What is deleveraging? If deleveraging is expected, why opposite rating actions?

Deleveraging denotes the winding down, or the paydown, of the principal balance on the secured notes for a given transaction. Most CLOs have a reinvestment period during which collateral managers may reinvest any principal proceeds received from the underlying assets. Once this time period ends, CLOs enter into an amortization period, which is when the principal payments from the underlying assets are usually used to pay down the CLO tranches in a manner as specified by that CLO. Though paydowns might also occur during the reinvestment period (for example, when a coverage test fails), systematic and significant deleveraging commences typically in the amortization period.

When deleveraging happens faster than what was expected based on the transaction expected amortization profile (given zero prepayments), then the potential for rating movement, and even the degree of significance of any upgrade to the ratings on the senior tranches, can be more rapid. This is what may typically drive upgrades to ratings on senior tranches soon after a transaction exits its reinvestment period, as well as the circumstance for multi-notch upgrades. However, paydowns from coverage test failures may not always lead to upgrades for non-AAA rated tranches.

Similarly, when the portfolio shrinks too rapidly and the transaction has suffered losses and/or credit quality of the assets supporting the tranches deteriorates, these circumstances could affect the junior tranche ratings.

Isn't the CDO Monitor supposed to warn of risk to the current ratings?

Yes and no. The S&P CDO Monitor tool assesses the changes to the portfolio relative to the closing portfolio and the impact those changes may have on the ratings assigned on the closing date. It is akin to a trading tool used during the reinvestment period, and may help the collateral manager evaluate the potential impact of their trades relative to the closing analysis. Once the CLO enters its amortization phase though, the trading activities are usually restricted by the CLO's documents, and generally, the S&P CDO Monitor is no longer required.

When can one expect such opposite rating actions? And why?

These typically occur in the amortization period of a CLO's life.

When principal paydowns commence during the amortization period--on a standalone basis and when there are no significant changes in the collateral portfolio such as a spike in defaults or trading losses--this deleveraging is a positive for the senior noteholders as their overcollateralization tends to increase with the decline in the senior note's balance. This is a prime reason for rating upgrades.

However, when the CLO incurs losses following the sale of the collateral within the portfolio at less than purchase price and/or poor recoveries on defaults, the junior notes are, as mentioned, the first to be affected by those principal losses given their location at the bottom of the capital structure. If those junior notes do not have sufficient subordination, these losses will start reducing their support right away. This deterioration is why their rating might be downgraded.

To summarize, when both principal paydowns (which increases the senior credit support) and the principal losses (that decreases the junior credit support) occur at the same time, it should not be surprising to see some rating upgrades and downgrades in the same transaction.

We also consider circumstances where the amortization of a portfolio causes increased concentration among the remaining loans. In our surveillance of CLOs, we apply supplemental tests in our cash flow and credit analysis that can constrain rating upgrades later in the life of the CLO and could even, in some cases of higher concentration risk, contribute to opposing rating movement to tranches within a CLO.

Another circumstance in the amortization phase where rating movements might diverge is a CLO that is nearing its final stated maturity--or even a redemption date--when the portfolio's liquidation value and the timing of that liquidation could pose risks to the remaining secured noteholders. The current par balance of the portfolio or proceeds from the portfolio's liquidation may appear to be sufficient to fully repay the rated noteholders in this scenario, but the downside may also occur. Some less liquid positions in the portfolio may need to be sold at less than par, attributing to losses, or may not be marketable at all in time for the CLO's final maturity, both of which would render the proceeds insufficient to cover the redemption prices of the rated tranches. At this point, the ratings on the CLO tranches are binary to the extent that the remaining rated notes principal and accrued interest balance will either be fully repaid or they will not. If more than one class remains outstanding, this could see some senior tranches getting fully repaid and, at the same time, junior tranches facing the risk of default.

What about CLOs during their reinvestment period?

We typically do not see this same dichotomy of change in credit support to the senior compared to junior tranches during the reinvestment period.

For one, the senior notes offer the lowest cost of funding, and so, they usually will not be paid down when the transaction is reinvesting and all coverage tests are passing.

However, let's consider a reinvesting CLO that has incurred principal losses from trading and/or defaults. Typically, at the beginning stages of the transaction, all CLOs have some excess subordination, even at the junior tranche levels. If the CLO incurs principal losses, this erodes this junior subordination as the first loss part of the CLO's capital structure. Low levels of junior subordination and credit support may lead to rating actions at this junior part of the capital structure if the par deterioration is such that the junior tranche(s) can no longer withstand the same economic and credit stress as before. In this situation, we are not seeing any countering support increases for the other rated notes.

Conversely, let's consider an amortizing CLO that experiences faster amortization than the expected amortization profile. Though the deleveraging boosts the credit support to the senior notes, the junior notes can still be exposed to a more risky portfolio if the amortization was primarily from higher quality assets. This leaves the portfolio with lower quality of assets to support the remaining rated tranches.

How frequently do these split rating actions occur?

These actions are relatively infrequent, although they have been more common amongst CLOs experiencing rating actions more recently.

In July, we took actions on CLOs whose junior tranches were on CreditWatch with negative implications due to performance; some senior tranche ratings were upgraded due to increased support following paydowns. Similarly, we have started to resolve the amortizing deals that are currently under criteria observation following the implementation of our updated criteria (see "Global Methodology And Assumptions For CLOs And Corporate CDOs," published June 21, 2019) a few months back. While most of the ratings actions were upgrades to the senior tranches due to both the application of the new criteria and paydowns, the junior tranche ratings of some CLOs were lowered.

We expect less of these now for the current reinvesting deals given the increased number of resets in the last few years that extended the reinvestment period/transaction life of many deals that might have otherwise started to amortize.

Related Research

• Various Rating Actions Taken On 32 Classes From Six U.S. Cash Flow CLO Transactions; Ratings Removed From UCO, Sept. 13, 2019
• Various Rating Actions Taken On WhiteHorse VII Ltd., July 31, 2019