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Are Rating Agencies Colluding to Prop Up the CLO Market?
Recent conversations, observations and insider tips led me to the following question – With over 60% of Leveraged Loan (LL) defaults occurring via Distressed Exchanges (DE), how did the rating evolve post-default?
As CLOs own 64% of all LLs, the treatment of DEs in CLOs is paramount to the entire LL market. And as goes the LL market, so goes Private Equity. CLOs and LLs are the sine quo non, without which Private Equity collapses.
My analysis revealed that 100% of DEs from 2025 were upgraded within days of default to at least CCC.
Rapid post default upgrades have 3 benefits for CLOs: 1) the loan could be given full value in performance (OC) tests, 2) improve average ratings and 3) improve loan investment eligibility.
As always comments welcomed.
Background
Rating Agencies (RAs) generally consider DEs as a default. How these DE loans are treated in the CLO OC tests is critical. DEs given discounted value in the OC test can cause it to fail, thereby shutting off cashflow to CLO equity and sub debt. Therefore, there is every incentive to ensure that the rating is upgraded to at least CCC.
In previous posts, I noted that most DEs redefault and therefore only delay the inevitable.
The Data Reveal
This analysis is based on data I compiled from S&P. I reviewed ratings following all 30 DE defaults in 2025.
My findings validated my concerns - 100% of the 30 DEs were upgraded to to CCC within days of default. Therefore, these defaults likely weren't reported to CLO investors as they mostly would have happened between reporting cycles. Even more curious, I found that nearly all upgrades were to CCC+ (22) with just one upgraded to CCC-. The fact that 22 were upgraded to CCC+ and only 1 upgraded to CCC- could indicate that S&P was guided to the desired rating, or equally problematic, S&P guided the structure to ensure a desired rating outcome. Possibly there is another explanation.
One might argue that the SD to CCC transition doesn't matter as long as the new rating is an accurate reflection of the risk. S&P's own language from an example UPGRADE press release reveals doubts about sustainability: "We view the company's capital structure as unsustainable..."