Further evidence that downgrades are the key concern for collateralized loan obligation managers in Europe has emerged, with J.P. Morgan publishing the latest results of its CLO survey (which has been running since 2009) showing that "almost half (45%) of participants consider loan rating downgrades as the biggest concern and 26% of participants voted for loan defaults."

While a savage wave of downgrades has yet to emerge in Europe, those that have are making a difference — and players are aware it is only a matter of time until downgrades gather pace.

CLOs are a critical investor component in both the European and U.S. leveraged loan markets. They have thresholds as to how much lower-rated debt they can hold.

J.P. Morgan says the concern among CLO managers makes sense, as "test failures can occur on a majority of CLOs if another 4-5% of loans in portfolios get downgraded, triggering manager trader restrictions."

As for other responses on key concerns, J.P. Morgan adds that 11% of its respondents voted for CLO rating downgrades, 10% for liquidations of CLO warehouses, 7% for CLO equity shutoff, and only 1% for a CLO event of default (this survey was carried out March 24–26, using 51 respondents).

Barclays research analysts have also been looking at loan downgrades, commenting in a piece on Friday — titled 'Downgrades off to the races' — that "We expect European loan downgrades to worsen materially. We have already started to see this play out with loans in the European Leveraged Loan Index (ELLI) being downgraded at a faster pace YTD than the same period in 2019. We count 20 downgrades by S&P YTD, versus 6 in 2019 YTD. Similarly, we count 12 downgrades by Moody’s YTD, versus 3 in 2019 YTD."

So far, the number of downgrades to triple-C — which have the greatest potential to damage CLOs — has been limited.

Downgrade roll call
Looking at S&P Global Ratings action only, the table below shows all the downgrades to triple-C, but of these, only Hurtigruten is in the European Leveraged Loan Index.

S&P Global Ratings earlier this month, in a piece titled "European CLOs: Assessing The Credit Effects Of COVID-19", highlighted that its downgrades into the triple-C category (along with how many CLOs hold them) were as follows: Hurtigruten (45), Codere (18), and Travelex (2). Those firms that have been pushed to B- territory are Vue (72), Cassini (40), Comet (7), and Amphora (6).

Meanwhile, an early look at the ratings composition of the ELLI shows little change yet over this quarter. The proportion of constituents rated CCC+ and below in the ELLI is currently 3.56%, up slightly from 3.15% in December (note, this compares to 2.79% in December 2008). Barclays adds that "CCC and Caa buckets [of CLOs] are still relatively low, with average Caa and CCC buckets at 2.4% and 1.8% in European CLOs, respectively."

Rather, much of the action is taking place in the single-B cohorts, mostly at B-, with the share of B+ credits in the ELLI falling 0.58%, to 21.1%, while the share of B and B- credits has risen 0.01% and 2.52%, respectively, to 42.88% and 14.04%.

According to Barclays, this pattern is reflected in activity by Moody’s, whose "ratings actions lower have been even more focused at the B2 level, further increasing B3 exposure of the loan market." Barclays adds that, "the number of loans on negative watch remains relatively low. However, this appears to also be accelerating with the majority of the loans on negative watch by S&P (8) being placed there in March, along with most of the loans on negative watch by Moody’s (5)."

Impact of downgrades
While the number of downgrades remains fairly low, they are accelerating — and the few that have come through so far are having an effect. Barclays notes that, "As a result of the increase in downgrades and assets placed on negative watch or outlook, European CLO WARFs have continued to rise. Median WARF scores are now approximately 2,980, with three vintages currently above 3,000 (2013-2015). For some context, a WARF of 2,720 equates to a B2-rated portfolio, and 3,490 to a B3-rated portfolio."

WARF stands for weighted average rating factor.

All of which means CLO managers "will have to be even more proactive going forward in managing ratings buckets. Especially if downgrades continue, with more concentrated around the B3 level, managers could see WARF scores increase at an even quicker pace with CCC buckets filling further," adds Barclays.

With that in mind, J.P. Morgan says its survey results show "there is a consensus on selling Autos, Energy, Gaming/Lodging/Leisure, and Retail whereas buying is more mixed, with Technology, Cable/Satellite, and Healthcare receiving the most buy votes. In percent terms in each sector, Metals and Mining and Retail are both 100% voted to sell, whereas Cable/Satellite, Financial, Food and Beverages, Paper and Packaging, Telecommunications and Utility are 100% voted to buy."

Still, cash balances are not huge, according to J.P. Morgan. "The majority of responses (51%) is in the Low (0-5%) category, but the proportion of Moderate cash balance (5-10%) has increased to 42% from 33% in Q1," adds the bank. "The High/Very High (10%+) portion reached its second lowest point since 1Q2012. The Add/Reduce ratio remains low, around 3.4x, the second lowest level since 2010, and while there is a large drop in investors looking to add risk, [the] majority (52%) of investors anticipate holding risk has reached the highest in our 10+year survey history."

This analysis was written by Luke Millar, who oversees European leveraged finance coverage for LCD in London.