When corporates undertake distressed (sub-single B minus) exchanges, the rating agencies treat the trades as a default on the basis that if they did not take place then bankruptcy would be imminent. The problem for CLOs holding such loans is that their downgrade to defaulted status can breach their triple-C bucket limits and place additional strain on structures already struggling to cope (see Loan market: Default rating's unintended consequences, Euromoney, May 2009). According to Citi, recent analysis of 585 US CLO transactions shows that roughly three out of every four fail their interest diversion test. Higher up in the capital structure, around 60% and 25% of deals fail their junior OC and their single-A-rated class OC tests respectively (but the report does note that the pace of downgrades into triple-C has slowed somewhat). When a loan is rated double- or single-B it is still treated as a par asset in a CLO, but when it is downgraded below that level it has to be held at market value.
With 50% of outstanding loans residing in cashflow CLOs, these implications need to be considered. "The way in which many CLOs are structured creates problems for them when debt exchanges happen," says Andrew Sheets, head of European credit strategy at Morgan Stanley.