In the wake of a whopping 114 loan downgrades by S&P Global Ratings in March, the share of outstandings in the $1.2 trillion U.S. leveraged loan market rated B– and below now stands at an all-time high, according to the S&P/LSTA Leveraged Loan Index. And the three-month rolling count of downgrades to loans in the Index has increased to 171, likewise a record.

While this activity is raising eyebrows across the credit markets, to say the least, it is of particular interest to CLO managers, who are growing increasingly concerned about the impact of downgrades on returns of their various CLO vintages, should portfolio tests start to fail as a result.

These recent downgrades were predominantly at the lower end of the ratings spectrum, and came at break-neck speed, even though the full scope of the global economic slowdown is yet to be understood (to be sure, the markets do not like uncertainty).

Even with the full effects of COVID-19, and its harm to the global economy, unknown, the latest three-month rolling downgrade count surpassed that of the Great Financial Crisis of 2007-08, when loan downgrades topped out at 169.

... tails you lose
The share of issuers the S&P/LSTA Index rated B– or lower rose to 28.2% in March, the highest ever, and a 2.4% jump from February. That is the largest monthly increase since November 2008, when this metric jumped 3.5%, to 24%.

Meanwhile, the share of the Index rated CCC or lower rose to 7.48% in March, an increase of 1.67% versus February.

This is a key number. Typically, CLOs are allowed to hold 7.5% of their collateral pool in triple-C debt. If that share tops 7.5%, tests within the CLO could start to fail. This, as well as the proliferation of B– credits that play havoc with a CLO's WARF test, are frequently described as the biggest concern for CLO managers in the current environment.

A WARF test measures a CLO's weighted average rating factor.

CLOs are the biggest investor segment in the $1.2 trillion U.S. leveraged loan market, accounting for some $700 billion of outstandings, according to market estimates. Their growth over the past several years has helped the loan market increase in size, and take a more dominant place in the overall capital markets.

The CCC reading is also the steepest increase in the triple-C share of the market since December 2010, which saw a jump of 3.15%. During the peak of the financial crisis the share of Index credits rated CCC or lower peaked at 11.46% in February 2009.

Another ominous record, on this front: The downgrade/upgrade ratio hit an unprecedented 11.4:1 at the end of March. The next-closest figure, which is compiled on a rolling three-month basis, is from January 2009, when the ratio totaled 8.45:1 on the back of 169 loan downgrades and 20 upgrades.

Mind your ABCs
Further highlighting today's uncharted credit environment—especially in relation to CLOs—Barclays late last week published analysis entitled “Clawing away at mezz returns and ratings” in which CLO and Loan Strategist Geoffrey Horton writes: “S&P notes that the US BSL CLOs it rates have seen more than 14% of their collateral (over 200 obligors) downgraded or placed on CreditWatch negative since early March. This had led to CCC bucket exposure broadly increasing, with close to 10% of US BSL CLO assets now coming from an issuer with a CreditWatch negative rating (as of March 29), versus 1.6% at the start of March.”

Partly because of this, Horton adds “rating agencies placed more than 50 US and European CLO tranche ratings on negative outlook in March alone. We think BBB through single-B tranches are more at risk of downgrades in the short term, especially from US BSL CLOs, as the rate of loan downgrades increase and defaults begin to rise.”

The good news is that, to date, the level of downgrades has been manageable for the CLO market, and no great pain has been felt. The bad news is that this may well be just the beginning, for no one knows how long the global turmoil and overall uncertainty will last.

This article was written by Luke Millar and Alexander Saeedy. Luke is the Senior News Desk Manager for LCD in Europe, and Alexander is a Senior Reporter for LCD.