In a recent press release (link here) Fitch was optimistic about the ratings resilience of CLOs, despite the enormous headwinds facing the underlying leveraged loan assets. They ran a number of stress scenarios and concluded:

"Under these stress scenarios, the overwhelming majority of ‘AAAsf’ rated notes from both regions remained stable."

I won't discuss my views on the sector in depth, as I have done so in a number of prior posts and articles. Despite limited ratings action thus far, I believe my original concerns largely remain valid and many have already played out to some extent (even if not reflected in ratings action - yet).

The press release does raise a number of unanswered questions:

1)Correlation Assumptions: There is no mention of correlation assumptions. Low correlation assumptions are the Sine Qua Non  of CLOs for all major ratings agencies. Without low correlation assumptions it would be nearly impossible to achieve any material  level of AAA ratings much less 60-70% AAAs for a typical CLO. Given that the entire underlying collateral is highly levered floating rate leveraged loans and universally vulnerable to the rapid rise in rates, I was a bit surprised to see no mention of increased correlation assumptions nor any mention of correlation stresses or modification from original rating assumptions.  

Correlation assumptions are a critical part of the Rating Agency methodology yet somehow fails to earn a mention in surveillance action (not just true for Fitch). Correlation assumptions, albeit more difficult to measure, should be considered a dynamic variable.

2) Accounting for recent recovery and interest coverage ratio plunge: There seems to be no recognition of the recent freefall of recoveries and no indication of changing base case recovery assumptions and no mention of recovery stresses. To properly assess the ability of AAAs to endure Fitch's stress scenarios, it's first critical that the base case assumptions are updated to reflect the far worse current state of play.  

3) Cushion in original rating: In my experience working at a ratings agency and sell side research, most securitized deals are structured to maximize the amount of AAAs issued (ie minimize the amount of credit support).

4) Maturity Wall: and impact on leveraged loan ratings: There is little indication that Fitch modeled the coming wall of maturities a time of a very challenging refinance environment. The ratings agencies somnambulant stroll through the current difficult LL and CLO landscape to some extent will improve the refinance environment as new CLOs (with inflated ratings in my view) provide a non-market offtake for refinancing of maturing loans. But CLOs can't absorb all of the loans needing refinance.

The relatively benign view expressed in Fitch's press release creates cognitive dissonance or a bit of Rashomon interpretation with headlines such as:

Default risks loom for nearly $2 trillion of junk-rated debt as US companies hit with higher interest rates

For example, according to a Bloomberg article: "companies rated B2 and below ... will have to deal with $206 billion of debt coming due in 2024 and 2025, Moody’s data shows".

Overall, while I would agree with the premise that AAA CLOs are well protected from default in the base case, it's entirely another matter to argue that downgrades of AAAs aren't warranted.