Loan buyback-related rating actions stir debate
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A wave of downgrades tied to loan buybacks is igniting debate in the leveraged loan and CLO markets, highlighting the growing tension between CLO managers and rating agencies.
CLO managers are already facing mark-to-market losses resulting from the growing number of loans rated below triple-C in their portfolios. The proportion of CLO portfolios with 15-20% of assets rated CCC+ or below went from about 13% last month to about 37% this month, according to a May 8 research report from Morgan Stanley, which based its calculations on a sample of 527 transactions (Fig. 1).
CLO managers are now dealing with an additional problem arising from rating actions that place issuers that buy back their loans below par in technical default. These technical defaults, managers say, artificially inflate the number of distressed loans in their portfolio, increasing the likelihood that many CLOs will go static.
Loan buybacks – which occur when an issuer buys back its loans in the secondary market – have gained in popularity as issuers look to retire debt in a sub-par market and reduce interest costs.
The buybacks, typically completed via an amendment process, are not coercive in nature, giving investors the flexibility to decide whether or not they would like to tender their paper at the price being offered by the issuer. In some cases, companies use cash on hand or increased equity contributions from private equity sponsors to de-lever.
In many cases, loan buybacks are being executed significantly below par, and, as such, are being viewed as distressed transactions by both Moody’s Investors Service and Standard & Poor’s, which, in turn, have been classifying the buybacks as limited default (LD) and selective default (SD), respectively.
“Given our rating methodology of rating to the original promise to pay, economic losses to investors caused by exchange offerings and similar restructurings are by our rating definition a default,” Mimi Barker, director of communications at S&P, said in an e-mailed statement.
To be sure, both agencies recognize that not all buybacks are distressed. In criteria reports released earlier this year, the agencies said they assess an issuer’s creditworthiness to determine if its buyback is distressed or merely opportunistic.
In Moody’s case, if an issuer rated Caa1 or lower implements a buyback that is at a significant discount to par, the transaction is highly likely to be considered a distressed exchange. When this rating is B1 or higher, the transaction is likely to be considered an opportunistic exchange.
S&P’s rating benchmark for identifying a distressed buyback is an issuer credit rating of B- or lower.
Distressed loan buybacks: A win-win for all?
Broadly speaking, both agencies contend that when a distressed buyback is classified as LD or SD, the agencies make assessments that there is a realistic possibility that the issuer would have filed for bankruptcy or fallen into payment default had the buyback not occurred.
For instance, in April, Moody’s downgraded Emmis Communications‘ corporate family rating to Caa2 from Caa1 and changed its probability of default rating to Caa3/LD from Caa2, while S&P lowered the company’s corporate credit rating to SD from CCC+.
The downgrades came on the heels of the company announcing that it would purchase its term loans at a 45% discount and that it had hired Blackstone Advisory Services LP to explore a possible amendment to its credit facility or a possible restructuring of some of its liabilities.
Subsequently, on May 4, S&P raised the company’s corporate credit rating back to CCC+ from SD after Emmis completed four sub-par Dutch tender offers, ultimately buying back its loans at an average discount of 43%.
The rating agencies’ underlying argument is that a distressed buyback is akin to an out-of-court restructuring and that by buying back its loan at a deep discount to par, a distressed issuer is likely avoiding default and not fulfilling the promise to repay its debt at its original terms.
“Bankruptcy is one way of restructuring your debt and reducing the promise you had made to creditors. A distressed buyback is another,” said Kenneth Emery, senior vice president in the Credit Policy division at Moody’s.
These distressed buybacks “can be beneficial for the company by reducing unsustainable debt levels and can be good for those creditors looking to crystallize losses. But the fact remains that the original promise to pay on this debt was not met,” he added.
But critics say investors themselves could stand to gain from a buyback transaction that is voluntary, especially when an issuer offers to buy back its loans above current market prices but below par. In fact, S&P, in its report, acknowledged that “holders may be very pleased with an offer that is above market prices, especially if they account for the investment on a mark-to-market basis.”
“Pre-offer, sellers have always had the alternative of selling the (loan) in the secondary market for less than the original promise,” wrote Chris Taggert, senior loan strategist at independent research firm CreditSights, in an April 22 report. “Why getting more for the (loan) from the seller’s perspective, and improving the capital structure to boot, is tantamount to a default is highly speculative.”
Old rules for a new market
The rating agencies’ argument has the institutional loan world up in arms because the feasibility of issuers repaying their debt on original terms has changed in light of the deterioration in the credit markets.
For one, today’s market, where the average bid on the 100 most widely held loans was sitting at 78.6 as recently as the end of April, is vastly different from the market that existed two years ago when the average leveraged loan was trading at or near par (Fig. 2).
“If you take a B2 or B3 rated company with a performing loan and you suddenly give it a selective default rating because it bought back its loans at a sizeable discount, you do severe, life-threatening damage to CLO investors,” said a CLO manager.
CLO managers dub the rating agencies’ technical default policies as crime and punishment that are disproportionate, stating that the agencies are exacerbating an already serious problem.
“With buybacks, you get de-leveraging, so why is the punishment so harsh,” said another CLO manager, adding that the rating agencies are using rules that were written for a different market and are applying them too literally now.
“The agencies are trying to prove that they’re purer than pure and a lot of people think it’s self-serving,” said a third manager.
Worsening an already serious problem?
The downgrade problem appears to begin early on in the buyback process. For instance, S&P, in its report, said that it generally lowers the facility and issuer credit rating to CC at the mere announcement or anticipation of a distressed buyback.
An example of this is Cinram International Inc., which announced at the end of the first quarter that it was seeking bank permission to amend its credit agreement to buy back up to $150 million of its term loan at a discount to par using an auction.
Like many other borrowers that have been engaging in buybacks, Cinram’s incentive came from its loan trading at a significant discount to par in the secondary market (Fig. 3).
Following the announcement, S&P said the company’s long-term corporate credit rating would be lowered to CCC+ from B for the duration of the buyback process, which could take up to a year, and that the corporate credit rating would be lowered to SD upon completion of the offer.
“Our downgrade today does not reflect a perceived increase in Cinram’s bankruptcy risk,” S&P said in its March 25 ratings release. “Rather, our downgrade is based on the financial pressure we feel Cinram is under to reduce its debt burden by retiring debt for less than originally contracted,”
Once the buyback is completed, the untendered portion of Cinram’s loan is likely to be upgraded, owing to the company’s de-leveraged capital structure.
The impact this fluctuation in ratings has on the loan market is by no means negligible.
At a time of rising defaults and severe liquidity constraints, downgrades or defaults resulting from buybacks add enormous pressure to ratings – and timing-sensitive investors such as CLOs (Fig. 4).
Due to falling prices on underlying loan assets, CLOs are already being forced to mark them to market and, in many cases, move them into their triple-C or default baskets. That, in turn, is reducing CLOs’ overcollateralization cushion (Fig. 5).
So, downgrades to triple-C or an assignment of SD or LD resulting from a loan buyback inflict even greater pain by triggering overcollateralization (OC) tests for those CLOs that choose to hold onto the loan in question instead of tendering it.
These CLOs are required to mark to market the price of the defaulted or downgraded asset based on its price in the secondary market.
The lesser of two evils
CLOs are having “to choose between two undesirable outcomes,” said one CLO manager. “Should a CLO crystallize a loss by selling back its paper to the issuer for a low price or should it take the hit on its OC test by keeping the paper?”
Market players estimate that over 50% of CLOs have breached their OC tests and that buyback-related defaults are a major contributor to that.
Another problem has to do with the time at which a downgrade or default rating is assigned. CLOs have reporting dates in which they do their OC tests. If the test falls on a day when the loan being bought back is assigned a SD/LD rating, then it has to be marked to market and that impacts the OC cushion.
If a CLO fails its OC test, it must redirect cash flows to its senior note holders, reducing what it can pay its equity investors. This affects CLO managers who either own the CLO equity piece or rely on subordinated fees that are contingent on passing OC tests.
CLO managers also say that by moving issuers to default, the rating agencies are, essentially, trying to measure an unobservable event. In other words, it isn’t always apparent that had it not done a buyback, an issuer that was downgraded to SD would have definitively defaulted on its debt.
“It’s a self-fulfilling prophecy because if companies cannot live to fight another day, it really does increase their chances to default,” said a CLO manager.
The future of buybacks
When asked if the rating agencies are putting additional pressure on the market at a time when the market can ill afford it, Emery from Moody’s said that “Moody’s needs to accurately capture default events and our definition of default has always included distressed exchanges. At the same time, it’s worth noting that Moody’s largely rates through these distressed buyback transactions and understands that the transaction can be beneficial to the capital structure of the company.”
A poll conducted by the Loan Syndications & Trading Association (LSTA) in mid-April asked what the likely outcome from the SD situation would be. Thirty-nine percent said the downgrades would cause more CLOs to trigger their OC tests and go static (Fig. 6).
Twenty-eight percent said borrowers would continue to do economically rational buybacks, while another 28% said CLOs would be forced to vote against buyback amendments, thus ending buybacks. The remaining 5% predicted other outcomes for the situation.