Fitch Ratings has published its revised criteria for rating collateralized debt obligations exposed to corporate debt.

The new criteria were developed after the firm completed a six-month review of its approach. The review included a fundamental re-assessment of Fitch’s approach to corporate portfolio risk where each component of the rating approach was challenged and re-tested. The result is a number of important revisions that are intended to create more stable, predictive ratings.

The firm notes that under the new criteria additional stresses are applied to capture risks posed by concentrations in sector, industry, or individual obligors. “CDO modelling to date has relied upon some expected minimum level of diversification. In recent times we have observed an increase in portfolio concentrations, and our updated framework brings this risk into much sharper focus,” said John Olert, managing director and head of Global Structured Credit at Fitch.

Screening tools are also applied to identify portfolio assets that may have an above-average likelihood of downgrade. “The early, and sometimes severe, downgrade of corporate CDO notes has been a vexing issue for the market. By identifying adversely selected assets, CDO holders can benefit from additional protection against credit deterioration in the underlying portfolio,” said Philip McDuell, managing director at the firm.

Fitch ceased new rating activity during the criteria review period, and with the publication of the methodology, lifts this self-imposed embargo. “To stop rating some types of CDO transactions last year was a necessary step in order to move forward constructively,” said Olert. “After intense discussion with the market and months of rigorous analysis internally, the revisions we are implementing are an important step in the restoration of market confidence in CDO ratings.”

The new approach will also be used to review existing transactions with exposure to corporate debt and all such transactions remain under analysis whilst the criteria is implemented. “Applying the updated criteria to existing ratings is important for market transparency and consistency,” said Roger Merritt, Fitch’s chief credit officer for Global Structured Credit.

While Fitch expects many ratings to be affirmed, downgrades are also expected, in some cases by several rating notches. “We expect the downgrades to be most severe in those transactions with portfolio concentrations, or those with little or no cushion in their current level of credit support,” said Merritt. “The extent of manager flexibility and other relevant qualitative considerations are also expected to be factors in the rating review. If a manager shows willingness and ability to mitigate portfolio risk, we will take this into account.”