Rating Methodologies (S&P, Moody's, Fitch)
Definition
Rating agencies evaluate CLO tranches using quantitative models that simulate portfolio losses under stress scenarios. Each agency employs distinct methodologies: Moody's uses Binomial Expansion Technique (BET) modeling default correlation and diversity scores; S&P uses CDO Evaluator with cash flow modeling and scenario default rates; Fitch uses vector analysis combining rating transition matrices with correlation assumptions. All agencies stress-test portfolios using target default rates (8-12% for AAA depending on WARF), recovery rate assumptions (60-70% for senior secured), and correlation factors (20-50% depending on industry concentration). Tranche ratings are assigned based on loss coverage under these stressed scenarios—AAA tranches must withstand severe stress with minimal impairment, while BBB tranches tolerate higher losses.
Why it matters
Rating methodology differences create arbitrage opportunities and structural biases in CLO markets. Moody's diversity score approach penalizes obligor concentration more heavily than S&P's scenario approach, creating tighter obligor limits for Moody's-rated deals. S&P's cash flow modeling captures time-value effects that Moody's simplified approach misses, leading to different required subordination levels—S&P might rate a 30% subordinated tranche AA while Moody's requires 32%. Post-2008, agencies recalibrated models with more conservative default and recovery assumptions, causing widespread downgrades. Understanding methodology nuances is essential for structuring CLO tranches efficiently and anticipating rating changes when portfolios deteriorate.
Common misconceptions
- •Ratings aren't price predictions—they measure probability of default/loss, not total return or mark-to-market volatility. AAA CLO tranches traded at 80 cents in March 2020 despite zero rating downgrades.
- •Rating agencies don't monitor portfolios in real-time. They review quarterly or when managers report breaches, creating lag where market prices reflect deterioration before rating changes.
- •Through-the-cycle ratings differ from point-in-time assessments. Agencies rate based on stress scenarios, not current portfolio quality, leading to rating stability during benign periods.
Technical details
Moody's Binomial Expansion Technique (BET)
Core methodology: BET models portfolio loss distribution using binomial expansion of individual loan default probabilities, adjusted for correlation. Key inputs: WARF (weighted average rating factor converting ratings to default probabilities), Diversity Score (measures portfolio concentration), Recovery Rate assumptions (typically 65% for senior secured).
Diversity Score calculation: Moody's converts obligor exposures into 'diversity score' representing effective number of uncorrelated exposures. Portfolio with 250 obligors but heavy industry concentration might score 150 diversity vs 220 for well-diversified portfolio. Lower diversity increases modeled tail losses.
Scenario default rates: Moody's applies stressed default rates based on rating target. AAA = 43% portfolio default rate with 2.23x par multiple (i.e., 96% cumulative defaults). AA = 32% default rate. A = 26%. BBB = 19%. These represent 'expected losses' at each rating confidence level.
Subordination sizing: AAA tranche requires subordination sufficient to absorb expected losses plus cushion. For portfolio with 65% recovery (35% LGD), 43% default rate × 35% LGD = 15% expected loss. AAA at 65% of capital structure has 35% subordination, providing 2.3x coverage (35% / 15%).
S&P CDO Evaluator methodology
Cash flow modeling approach: S&P uses deterministic cash flow modeling under scenario default rates. Models monthly cash flows over full CLO life, applying defaults at specified rates and timing patterns. Captures time-value effects, reinvestment dynamics, and interest rate scenarios.
Scenario default rates: S&P applies rating-specific default rates to entire portfolio. AAA = 'CC' scenario (38-42% defaults depending on WARF/diversity). AA = 'CCC' scenario (29-33% defaults). A = 'B' scenario (21-25%). BBB = 'BB' scenario (14-18%). Lower scenarios than Moody's but incorporate timing effects.
Recovery rate assumptions: S&P assumes 70% recovery for senior secured first-lien, 35% for second-lien, 45% for senior unsecured. Adjusts for covenant-lite (5-point haircut), industry (cyclical industries get lower recoveries), and jurisdiction (US vs Europe).
Liability-side stresses: Unlike Moody's, S&P explicitly models liability refinancing risk, manager fee structures, and expense increases. Incorporates interest rate scenarios (base, +300 bps, -100 bps) to capture CLO liability repricing risk. More comprehensive but computationally intensive.
Fitch vector analysis approach
Rating transition matrix: Fitch uses rating migration matrices showing probability of rating changes over time. Models how portfolio composition evolves as loans migrate from BB to B to CCC to default. Captures portfolio deterioration dynamics missed by static approaches.
Correlation assumptions: Fitch applies asset correlation of 20-50% depending on industry concentration and obligor overlap. Higher correlation increases tail risk—probability of simultaneous defaults rises nonlinearly. Uses copula models to generate correlated default scenarios.
Stressed scenarios: Fitch AAA = 35-40% cumulative defaults with correlation-adjusted losses. Incorporates 'ratings compression' where rating transitions accelerate during stress (BB migrates to CCC faster than historical averages). More conservative than base case migration rates.
Sensitivity analysis: Fitch publishes rating sensitivity to parameter changes—shows how many notches tranche would move if WARF increases 100 points, recovery decreases 10 points, or correlation increases 10 points. Provides transparency into rating stability.
Methodology evolution and post-crisis changes
Pre-2008 assumptions: Agencies used 70-75% recovery assumptions, 15-20% correlation, and historical default rates. Models assumed liquid markets and timely workouts. AAA tranches sized at 60-65% of capital structure.
Post-crisis recalibrations (2009-2011): S&P reduced recovery assumptions to 65%, increased scenario default rates 20-30%, incorporated liquidity haircuts. Moody's introduced diversity penalties for covenant-lite exposure. Fitch increased correlation assumptions from 20% to 30-40%.
2019-2020 refinements: Agencies added specific stresses for leveraged loan characteristics—covenant-lite loans, add-back quality, private equity sponsor concentration. S&P introduced 'weak links' approach identifying portfolio vulnerabilities. Moody's added CCC concentration penalties.
Current state (2024-2025): Agencies converging on more conservative assumptions but maintain methodological differences. All three require 25-30% subordination for BBB ratings (vs 18-22% pre-crisis). Rating stability improved but agencies criticized for lag in downgrading deteriorating credits.