Top CLO slices can resist severe defaults -Moody's

LONDON, Aug 5 (Reuters) - As the global default rate rises, stress tests on collateralised loan obligations (CLOs) show that typical investment-grade tranches could survive historically severe credit conditions, Moody's Investors Service said.

The typical triple-A tranche in a CLO would not lose until defaults exceed half the underlying portfolio at a recovery rate as low as 40 percent, the ratings agency said in a report released late on Monday.

By comparison, the worst five-year single-B corporate bond default rate was 49 percent in the Great Depression, and the worst five-year rate since 1970 was 33 percent, the report said. The annual average recovery rate for senior secured bank loans is about 70 percent, with the worst rate so far at 51.4 percent.

Analysis of a typical transaction shows that "investment-grade CLO tranches, especially Aaa tranches, can withstand some of the most stressful corporate credit scenarios in history", the report said.

The typical low-investment-grade Ba2 tranche would survive below 40 percent defaults with 60 percent recovery, it said.

A CLO is a pool of leveraged loans sliced up by degrees of risk. The riskiest "junk"-rated piece takes the first few percent of losses from any loan in the portfolio. After it is wiped out, losses move to the next tranche, and so on up the structure to the triple-A rated tranches at the top.

The credit crisis has led investors to shun tranched products including CLOs as they have lost confidence in the validity of their credit ratings.

Significant issuance of CLOs started in 1996 and grew to $120 billion in 2007.

CLOs have shown strong performance historically, Moody's said, with no single-A to triple-A tranches experiencing a loss and average loss rates for Baa-rated tranches at 0.8 percent, versus 1.1 percent for Baa corporate bond issues.

Furthermore, CLOs rated after 2001 have experienced no ratings downgrades so far, it said.

That performance is based on the fact that bank loans are at the top of a company's credit ladder and are often secured by assets, the agency said. Also they can be prepaid without penalties, giving CLO managers cash flows that can be used to strengthen structures.

"However, we note that during the peak of the lending cycle in 2006 and the first half of 2007, corporate loan underwriting standards declined," Moody's said, citing a rise in covenant-light loans and second-lien loans.

Moody's forecasts that the five-year global "junk"-rated corporate default rate will rise to 26.1 percent by 2013.

As of end-2007, 3.7 percent of issuers were on review for downgrades and 10.6 percent had negative outlooks, it said.

Furthermore, "not all CLOs are the same" as some portfolios are less diverse or include other types of assets that are riskier than bank loans, the agency said. (Reporting by Jane Baird; editing by Tony Austin)