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Gaining from a higher diversity score, but only up to a point

admin | September 27, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Many CLOs investors rely on Moody’s diversity score to evaluate the stability of returns in the underlying portfolio of leveraged loans. Stability does not rise linearly with diversity score, however. It is a game of diminishing returns. A simple analysis suggests the expected stability of portfolio returns does not improve materially beyond a diversity score of 75.

Extracting stability signals from portfolios with varying diversity scores

Stability in returns should rise with more diversification. At least that is the prediction of portfolio theory if each new asset has a correlation with existing assets of less than 1.0. If one asset in the same portfolio performs poorly, other assets may perform better in the same period. And if one asset outperforms others, its higher return will be diluted on a portfolio level. In either case, allocating capital across multiple assets allows the portfolio’s returns to be less volatile.

Moody’s diversity score for CLOs is based on the issuers and industries associated with the underlying loans. Moody’s starts by calculating the average par amount per issuer in a CLO portfolio. It then finds the ratio between every issuer’s par amount and the average par amount. This ratio is capped at 1 and is known as the unit score. Issuers’ unit scores in the same industry are summed up as each industry’s aggregate unit score. These aggregate unit scores are subsequently mapped according to Moody’s table into industry diversity scores, with the maximum industry diversity score usually around 5.0. The CLO’s diversity score is the sum of its industry diversity scores. Since Moody’s splits the world into 33 industries, the maximum diversity score is 165.

Gauging stability of returns and certainty about the stability over different diversity scores

Exhibit 1 shows the average annualized volatility for portfolios with different diversity scores. The benefit of having more industries, or a higher diversity score, is more pronounced when the portfolio starts with fewer industries. Average volatility for portfolios with 1 industry decreases by 60 basis points when 4 more industries are added. Meanwhile, average volatility for portfolios with 20 industries drops by only 4 basis points when 5 more industries are added. The drop in volatility – or gain in stability – is much higher for portfolios with a lower diversity score. After a portfolio has about 15 industries, adding more industries makes minimal impact on the stability of the portfolio.

Exhibit 1: Average annual volatility decreases faster for portfolios with lower diversity scores

Note: The S&P LLI dataset contains monthly returns for a total of 38 industries from September 2008 to August 2019. Only returns between August 2014 and August 2019 are included in this analysis. The 38 industries in the dataset are not identical but very similar to the 33 industries listed in Moody’s diversity score methodology. Starting with 1-industry portfolios, this analysis drew 1 industry out of the 38 possible industries. It then pulled the LLI monthly returns for that industry as the portfolio’s monthly returns. (If the portfolio contained more industries, its returns were averaged across its industry returns.) Repeating this process 1,000 times gives 1,000 series of portfolio returns. An annualized volatility was calculated on each of the series. The mean and standard deviation for the annualized volatility of all series was recorded above. This procedure was then repeated for portfolios with 5, 10, 15, 20, and 25 industries. For the portfolio with 38 industries, as it was the “market” portfolio, its mean annualized volatility was the volatility for returns averaged across all industries, with no uncertainty. Sources: S&P LSTA Leveraged Loans Index (LLI), Amherst Pierpont Securities.

These estimates for average volatility are better seen in light of the certainty around them. This certainty is measured by the size of the vertical bars (Exhibit 1) indicating a standard deviation above and below the average volatility. If there is more certainty about the expected volatility of portfolios, then the vertical bar is shorter, since the actual volatility could fall into a narrower range. For portfolios with 1 industry, there is a 68% chance that the annualized volatility could fall anywhere between 1.2% and 6.8%. Then for portfolios with 15 industries, annualized volatility could take values between 2.7% and 3.7%. The dispersion around the average volatility decreases as diversity score increases, suggesting a rising level of confidence in the estimated stability.

Moody’s lens at diversification is useful among others

Moody’s method for scoring diversification encourages CLO managers to allocate their assets across more industries, especially if their portfolios are concentrated in very few industries. This method helps managers improve the stability in returns of their portfolios and get more comfortable with the estimated stability. After a portfolio’s diversity score reaches 75, the marginal increase in stability of returns and confidence about that stability is very small.

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