CLO is a kind of securitized products which build CLO
tranches based on cash flows from a leveraged loans pool. In order to analyze
the performance of CLO tranches, we need to know the information of the
leveraged loans in the pool. These loans’ Probability of Default (PD), Recovery
Rate (RR), Default Correlations and Prepayment rates, are needed for us to have
a better understanding of a CLO deal.
Here I would like to introduce a Moody’s methodology [1]
on CLO analysis. The methodology is aimed to give a rating to CLO tranches.
Since prepayment do not affect the credit rating, so no prepayment is discussed
here.
Probability of
Default
Moody’s calculates the expected average default rate with their
rating factors weighted by par value. WARF is short for the Weighted Average
Rating Factor. The rating factor number indicates the 10-year accumulative
default probability of the asset. For example, Aaa asset has a rating factor of
1 which means a 10-year accumulative default probability of 0.01% and the Caa3
has a 10-year default rate of 80.7%.
Moody’s Default Probability
Ratings vs. Moody’s Rating Factors
Moody's Default
Probability Rating
|
Moody's Rating Factor
|
Moody's Default
Probability Rating2
|
Moody's Rating Factor3
|
Aaa
|
1
|
Ba1
|
940
|
Aa1
|
10
|
Ba2
|
1350
|
Aa2
|
20
|
Ba3
|
1766
|
Aa3
|
40
|
B1
|
2220
|
A1
|
70
|
B2
|
2720
|
A2
|
120
|
B3
|
3490
|
A3
|
180
|
Caa1
|
4770
|
Baa1
|
260
|
Caa2
|
6500
|
Baa2
|
360
|
Caa3
|
8070
|
Baa3
|
610
|
Ca, C
|
10000
|
Source: Moody’s Investors Service
Since the rating factor indicates the 10-year default rates, we need to do linear interpolation when the pool’s Weighted Average Life (WAL) is not 10 years. We may also adjust the rating when there are review on loans of upgrade or downgrade.
Default Correlation
A CLO deal normally have more than 150 loans in its pool, so
explicit calculation of correlation would be explosive. Moody’s uses an
implicit method to model the default correlation with the diversity score. This
score considers the loan volumes of different industries, and how many industries
are covered in the pool.
Moody’s uses a binomial distribution with diversity score as
the total trial (round down to an integer) to derive the loss distribution. If
the loan pool is heterogeneous along some measures, we may need to use more complex
distribution like multi binomial approach or a full simulation.
Recovery Rate
The recovery rate is the percentage will be recovered when a
default happens. According to the appendix 3 in the report [1], the
higher rating loans have lower recovery rate. Moody’s examines the difference
between the instrument rating and the Default probability rating. The higher
the difference, the higher the recovery rate.
Recovery rates of First-Lien
Senior Secured Loans (Instrument Rating - Moody’s Default Probability Rating)
Target Rating
|
-1 Notch
|
0 Notch
|
1 Notch
|
Aaa
|
40.00%
|
45.00%
|
50.00%
|
Aa1
|
40.00%
|
45.00%
|
50.00%
|
Aa2
|
40.00%
|
45.00%
|
50.00%
|
Aa3
|
41.70%
|
46.70%
|
51.70%
|
A1
|
43.30%
|
48.30%
|
53.30%
|
A2
|
45.00%
|
50.00%
|
55.00%
|
A3
|
46.70%
|
51.70%
|
56.70%
|
Baa1
|
48.30%
|
53.30%
|
58.30%
|
Baa2
|
50.00%
|
55.00%
|
60.00%
|
Baa3
|
51.70%
|
56.70%
|
61.70%
|
Ba1
|
53.30%
|
58.30%
|
63.30%
|
Ba2
|
55.00%
|
60.00%
|
65.00%
|
Ba3 to C
|
55.00%
|
60.00%
|
65.00%
|
Source: Moody’s Investors
Service
Conclusion
The WARF is an important measure when we look at a CLO deal.
Lower WARF indicates the pool has more highly rated loans, and it is normally
safer than high WARF pool. The diversity score gives us an idea on the
concentration risk, it also affects the portfolio level default rate and loss
distribution. However, the recovery rate in the Moody’s reports looks not that
intuitive for me, especially that the lower rated loans have higher recovery
rates. I may need to do more research on it.
Reference
[1] ‘Moody’s Global Approach to Rating Collateralized Loan
Obligations’, Moody’s Investor Service, Feb.
27, 2014
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