What it means
Credit rating agencies grade borrowers with letters, but letters cannot be averaged. WARF solves this by giving each rating a number, called a rating factor, with higher numbers for lower-quality borrowers and the increase growing steeply as quality falls.
The pool's WARF is the weighted average of the factors of its loans, where the weights are the share of each loan in the pool. A pool with mostly strong borrowers has a low WARF, while a pool with many weak borrowers has a high one.
Managers and investors in collateralised loan obligations rely on the measure, because rules in the deal documents often set a maximum WARF. The manager must keep the pool within that limit when buying and selling loans.
The factors come from a published table maintained by the rating agency whose methodology is used, so readers must use the table specified in the documents. The numbers below are used for illustration of the method.
Like any average, WARF can hide concentrations. Two pools with the same figure can contain very different mixes, so analysts also look at the share of the weakest loans and at the diversification of the pool.
WARF is also sensitive to downgrades. Because the factors rise steeply, moving a loan down by one notch increases the figure by more when the loan is already weak, so a handful of downgrades can use up the headroom a manager thought it had.
For this reason managers keep a buffer below the maximum and watch for borrowers at risk of a downgrade.
In practice
Real-world examples.
Example
A loan fund manager reviews her portfolio before buying a new loan. Adding a weaker-rated loan would lift the WARF above the limit set in the deal documents, so she chooses a stronger borrower instead. The decision costs some yield, but it keeps the pool inside its limits.
Example
An investor compares two collateralised loan obligations. One has a WARF of 2,700 and the other 3,100, so the investor expects the second to have more defaults and demands a higher return.
Example
A rating analyst stress-tests a pool by assuming that several borrowers are downgraded by one notch. The WARF rises, and the analyst checks whether the deal still meets its tests. The result shows investors how much room the manager has before restrictions begin to apply.
Formula
Calculation
WARF = sum of (share of pool x rating factor of that rating)
Suppose a pool has 50% of its value in loans with a factor of 610, 30% with a factor of 1,350 and 20% with a factor of 2,720, using illustrative figures from a published table. The calculation is (0.50 x 610) + (0.30 x 1,350) + (0.20 x 2,720) = 305 + 405 + 544 = 1,254. If the deal documents set a maximum WARF of 1,300, the pool passes the test with 46 points of room. If the 20% slice with a factor of 2,720 were instead rated at a factor of 3,490, that slice would contribute 0.20 x 3,490 = 698, WARF would become 305 + 405 + 698 = 1,408, and the test would be failed.Case study
Seen in the real world.
Copperfield Credit Partners is an illustrative, fictional manager of a pool of corporate loans. Its documents set a maximum WARF of 3,000, and the pool stood at 2,850 at the start of the year.
After an economic slowdown, rating agencies downgraded several borrowers, and the WARF rose to 3,120. The manager could no longer buy new loans freely, and it had to sell some weaker loans and replace them with stronger ones to restore compliance.
Selling at a time of market stress meant accepting lower prices, which reduced the return to investors. The illustrative lesson is that the measure acts as an early warning, and managers need room to absorb downgrades. Copperfield now targets a WARF at least 150 points below the limit when it buys new loans.
Watch out
Common mistakes.
- Treating WARF as a probability of default, when it is a weighted score based on ratings.
- Comparing WARF figures that use different rating agencies or tables.
- Ignoring concentration, since a low average can hide a handful of very weak borrowers.
Questions
People also ask.
Does a lower WARF mean a better pool?
It means the pool has stronger average credit quality, but returns are usually lower too, so a low WARF is not always the best choice for every investor. Some investors accept a higher WARF in return for a bigger yield.
Why do rating factors rise so steeply?
Default risk climbs rapidly as ratings fall, so the table gives much higher numbers to weak ratings than to strong ones.
Who calculates the WARF?
The collateral manager or trustee usually calculates it from the pool data using the agency table named in the deal documents.
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