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May 19 (The following statement was released by the rating agency)
Fitch Ratings says its recently published Criteria for Sovereign Risk in Developed Markets for Structured Finance and Covered Bonds will not have an immediate impact on ratings for European CLOs. However, the new criteria reduce the available cushion for 'AAAsf' ratings, which will become more sensitive to any deterioration in performance.
Most European CLOs have partial exposure to loans extended to borrowers which are domiciled in Spain, Italy or Ireland or receive a substantial share of their revenues from these countries. For first generation CLOs that closed before 2008, the exposure to these three countries is generally less than 15%. For second generation European CLOs, starting from 2013 the manager is only allowed to invest up to 10% of the par amount in assets from countries with a sovereign rating below 'A-'. Although the limit would include other jurisdictions as well, in practice this limit effectively relates to Spain, Italy and Ireland as the only countries with significant volumes of outstanding leveraged loans. The Country Ceiling for all three countries is currently 'AA+'.
While the ratings of SF transactions from Spain, Italy and Ireland are currently capped at 'AA+sf', CLOs can still achieve a 'AAAsf' rating due to their partial exposure to these countries. In particular, Fitch would assign a 'AAAsf' rating to CLO notes whose credit quality is sufficiently strong to withstand the stresses resulting from the possible exit of all three countries from the euro, which would cause at the very least significant performance volatility for the underlying borrowers, currency transfer and convertibility (T&C) issues and FX risk for any proceeds from outstanding loans. Fitch believes that the borrowers are likely to default in such a scenario and as a result the T&C and FX risk following a euro exit would primarily apply to any recovery proceeds.
Under the current market circumstances, our CLO analysis will therefore assume all borrowers from countries with a Country Ceiling below the target rating to default. For example for a typical second generation European CLO with the 10% investment limit in countries with a sovereign rating below 'A-', the usual projected default rate for the 'AAAsf' scenarios is approximately 60%, which would be assumed to include a 10% exposure to Spain, Italy and Ireland. The remaining 50% of defaults would be spread across other countries, which would be consistent with Fitch's typical 'AAAsf' default expectations for portfolios not exposed to countries with a Country Ceiling below the target rating. The total default rate assumption would remain unchanged. The expected recovery rate at a 'AAAsf' rating for the 10% exposure bucket will be reduced by 50% assuming a devaluation of the currency against the euro. As a result the aggregate recovery assumption for a 'AAAsf' rating scenario for a typical second generation CLO would decline to 32% from approximately 35%.
The approach currently only applies to 'AAAsf' rating scenarios but this may change if the Country Ceilings were downgraded or managers started to include sizable exposures from countries with a Country Ceiling lower than 'AA+'.