Some partial defaults may escape CLO defaulted security treatment, says PF2

In a research report entitled The corporate loan and CLO conundrum, Gene Phillips of PF2 Securities Evaluations notes that CLO indentures differ in the way they define defaulted securities. Defaulted securities must be carried in CLOs at either the market price or the rating agency recovery rate assumption. Typically, a defaulted security is defined as one where the issuer has been declared bankrupt, where there is a default under the governing documents of that debt instrument, or where there has been a failure to make a principal or interest payment.
However, says Phillips, some CLOs include only the last of these definitions, and this can exclude some securities that are "lightly" in default. As an example, Solutia was in at least 18 cashflow CBOs and CLOs when it filed for bankruptcy in 2003. However, because several of its bonds continued to pay interest, they could have escape the definition of default in at least four of these 18 CDOs. Despite this, writes Phillips, two of the CDOs liquidated their Solutia bonds immediately upon the chapter 11 filing. A third deal carried the Solutia bonds as if they were defaulted, at 30%.