Institutional investors are turning to rated repackaged debt tranches to gain exposure to direct lending funds or private debt strategies. But repackaged debt is generally only attractive if credit-linked notes achieve an investment-grade rating. Considering the non-investment-grade profile of private debt portfolios, the rated instruments need credit enhancement. They normally benefit from over-collateralisation (OC), either in the form of excess spread, additional refundable reserves, or a lower instrument notional compared to the fund’s net asset value.

Scope designed seven scenarios assuming one class of 10-year notes for a notional equal to a EUR 400m portfolio notional; four for excess spread, two for cash reserves and an OC scenario:

ES1: Excess spread is used to early-amortise the notes
ES2: Excess spread is used to invest in new assets during the reinvestment period after which the notes amortise
ES3: Excess spread is used on a “use it or lose it” basis, i.e. only covering portfolio losses; otherwise it is paid as variable coupon to investors and not used to repay the rated promise
ES4: As ES2 but only to the extent that the ratio portfolio NAV/Notional of notes is above 105%; remaining excess spread is paid as variable coupon.
CR1: A cash reserve of 5% of the notional of the notes is funded at inception; the reserve amount is maintained at the maximum of cumulative loss ratio and 5%.
CR2: A cash reserve of 5% of notional is funded using excess spread; the reserve amount is maintained at the maximum of cumulative loss ratio and 5%.
OC: Issued notes represent 95% of the portfolio notional (EUR 380m instead of EUR 400m in all other scenarios); excess spread is used to cover portfolio losses.

Using the assumptions described above, Scope calculated the cash flows of the scenarios and computed the expected loss of the notes. To highlight the sensitivity of the different scenarios to defaults happening late in the transaction’s life, the expected loss of the notes was computed using a higher weighted-average default timing of 3.5 years.

“In the base case, expected losses are very similar due to smooth default-timing assumptions,” said Benoit Vasseur, executive director in the structured finance team of Scope and co-author of a report out today. “In the backloaded default scenario, the results show more dispersion. When the default rate is high, the protective measures specific to the structures (excess spread or cash reserve) kick in early in the life of the transaction.”

Sebastian Dietzsch, director in the structured finance team and co-author, added: “in general, a typical B rated portfolio repackaged and enhanced by excess spread (5% in this example) exhibits a 6-10 notch uplift in model output on the note level. As long as the excess spread is retained in the structure to offset the defaults as they occur, the scenarios show comparable results.”

The full report, which runs through and compares the outputs from Scope’s seven scenarios, can be downloaded here.