OREANDA-NEWS. China Shanshui Cement Group's default announcement last week will test how Chinese CLO structures withstand underlying corporate defaults, says Fitch Ratings. This event highlights the concentration risk prevalent in typical Chinese CLO structures. Fitch considers a lack of financial information on underlying loans, and high concentration risk, as the two major obstacles for rating Chinese CLOs at high rating levels.

Fitch downgraded Shanshui's Long-Term Issuer Default Rating (IDR) on 11 November to 'RD' (Restricted Default) from 'C', following the company's announcement that it had filed a winding-up petition and an application for the appointment of provisional liquidators with the Grand Court of the Cayman Islands the day before. The company said that it was not able to repay around CNY2bn (USD314m) of onshore debt due 12 November 2015, and a default on the onshore debt would trigger the cross-default provisions of its other debt.

A fully owned subsidiary of Shanshui is one of the obligors in Tianyuan 2015 Collateralized Loan Obligations (CLO) Trust Series One (Tianyuan), which was issued in July 2015 by Tianjin Bank. The debt owned by Shanshui's subsidiary, sized at CNY200m, constitutes approximately 16% of the transaction's outstanding principal balance at the time of announcement, up from 11.89% at closing.

At issuance, the underlying collateral of the CLO comprised 24 loans from 22 obligors totalling CNY1.68bn (USD263.6m). The top four obligors' borrowing was CNY200m (USD31.4m) apiece, amounting to 11.89% of the portfolio each at closing. The top five obligors combined contributed 53.51% of the trust's original balance. The concentration risk was heightened after the first distribution date in August when the number of loans was reduced to 13 from the initial 24. Default of a single top obligor, assuming no recoveries, will reduce credit enhancement (CE) to the senior notes to CNY77m, exposing senior notes to significant risk of future loss. This is despite a senior/sub structure, where subordinated bonds initially provided CNY277m CE for the senior tranches.

Chinese CLO transactions can be highly concentrated. A typical deal may have 20-50 obligors, and may be highly concentrated towards single obligors as well as certain industries and geographic regions. In the case of Tianyuan, loans originated in Shandong Province constituted 47.56% of the portfolio at closing, while loans from Shanghai and Hebei Province contributed another 20.93% and 17.84%, respectively. Construction, non-metal mining and coal mining were the top three industries, representing 23.90%, 23.78% and 11.89%, respectively.

To achieve high ratings from Fitch, a CLO either needs to be diverse in nature or have sufficient CE to mitigate the concentration risk within the underlying portfolio. CLOs rated highly by Fitch are typically diversified in terms of obligors, industries and regions. For example, a typical US CLO transaction has 150-200 obligors and documented caps on single-obligor concentration of 2%-3% of the portfolio. Furthermore, documentation also often includes limits on the maximum exposure to a single industry of around 15% of the portfolio. Fitch believes that credit portfolios that are less diversified with higher concentrations in terms of obligor, industry and region, could exhibit higher volatility of defaults rates - and therefore require more CE to achieve the highest rating.