Fitch Updates Global Rating Criteria for CLOs and Corporate CDOs
The updates include primarily; (i) an explicit description of the stress portfolio construction for managed CLOs, (ii) publication of the FX stresses for GBP and USD to the EUR for multicurrency CLOs, (iii) publication of the default skew assumptions for multicurrency CLOs, (iv) removal of the Portfolio Credit Model (PCM) default timing, and (v) the use of recovery estimates provided by the corporate analysts to supplement Recovery Ratings.
Fitch provided additional detail on the methodology used to construct stress portfolios in the rating of new transactions. Typically, Fitch starts with the initial "indicative" portfolio provided by the arranger and then maximises certain concentration limitations. The indicative portfolio provides a good indication of the portfolio the manager is likely to purchase, at least for US CLOs with a broader universe of leveraged loans. In the case of most European CLOs, which are selected from a much smaller universe and therefore exhibit significant overlap, Fitch uses a standardised stress portfolio that is customised to the specific portfolio limits for each transaction.
Fitch recently rated a multi-currency CLO where it published the FX stresses used in that transaction, but the agency has now published in greater detail the methodology in addition to the assumptions for both the USD and GBP to EUR stresses. In developing these assumptions, Fitch conducted a historical analysis of the exchange rate movement, as well as exchange rate forecasts. Fitch also considered in its historical analysis macro-economic explanations for significant exchange rate movements. Lastly, Fitch published the default skew that would apply a proportionately larger share of defaults to one currency bucket. The committee will use its discretion in applying this skew, depending on the size of the unhedged exposure.
Fitch will no longer apply the PCM default timing in its cash flow analysis for rating CLOs. As default timing is not a driver of our analysis Fitch therefore believes analysis can benefit from simplification. In addition to using Recovery Ratings Fitch has also incorporated the specific recovery estimates issued by the corporate group. The portfolio credit model was updated to allow users to enter both the Recovery Rating and Recovery Estimate, where available. Fitch's corporate team provides Recovery Estimates to managers, who use these to compute the Fitch weighted average Recovery Rating (WARR) for European CLOs. The use of Recovery Estimates in Fitch's analysis means the base case Recovery Rate will match the WARR computed by the CLO manager.
Fitch expects the criteria changes to have a minimal impact on the ratings for leveraged loan CLOs since this report largely reflects our current methodology. As mentioned, the removal of the PCM default timing is not expected to have any impact as it is not a key driver. The inclusion of Fitch Recovery Estimates will be marginally positive since the estimates are currently slightly above the midpoint of the corresponding Recovery Rating range. There is no rating impact on new ratings, which are based on the stress portfolio. The impact on existing ratings is expected to be limited to one notch.
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