A credit rating downgrade wave of historical proportions is following in the wake of economic disruption caused by COVID-19, swelling the ranks of riskier debt issues (those rated B-minus and triple-C), and potentially challenging Europe’s all-important CLO investor base in a way not seen since the global financial crisis more than a decade ago.
European ratings had been under pressure even before the coronavirus, with downgrades outweighing upgrades every month (on a rolling three-month basis) since April 2017, according to LCD. This trend had also accelerated in the past year, as private equity took advantage of the then-hot markets — and relatively disappointing M&A supply — to lever-up holdings to fund dividends or opportunistic acquisitions. The erosion of lender protections, through weaker documentation, has only served to exacerbate these trends, and analysts predict lower recoveries from any uptick in defaults in the coming 12 months.
Already, the effect of COVID-19 on corporate credit quality has been severe. LCD’s data is based on facility, rather than corporate, ratings, and shows that in the three months to April 17, the S&P European Leveraged Loan Index (ELLI) recorded 51 downgrades and only one upgrade. This dominance of downgrades is of a magnitude not seen since January 2012, when Europe was feeling the effects of the sovereign debt crisis in countries such as Greece and Portugal.
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Wave pattern
Few think this current wave will be the last.
"Once second-quarter results start to come through, there will be a lot more downgrades," said a fund manager. "Nothing is going to be upgraded."
The weight of these downgrades will have a dramatic impact on the credit profile of Europe's sub-investment grade loan market and, by extension, those that invest in it. Indeed, less than two months since the start of the lockdown in Italy (the first in Europe), the share taken by B- and triple-C rated deals in the ELLI has risen to 21.5% — a level last seen in 2012 (again, based on facility ratings). When looking at triple-C deals only, that share rises to a six-year high, at 5.4% as of April 17.
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This rapid and sudden deterioration in credit quality will bring a challenge for structured investors such as collateralized loan obligation vehicles, akin to the shock following the collapse of Lehman Brothers in 2008, sources said. For example, the latest crisis has effectively shattered ratings-based WARF tests (Weighted Average Rating Factor tests, broadly used by rating agencies to gauge the credit quality of a CLO's portfolio), which were already under pressure due to high B-/B3 issuance over the past couple of years, accounts say.
“WARF tests are an irrelevance now,” said one manager, who noted the effect is so bad that the very worst results are almost preferred, as these are the easiest to improve through new buying.
Triple threat
The more immediate concern for many, though, looking at CLOs' assets, is a rapid filling in baskets containing loans rated triple C, which are limited to 7.5% of total assets for most CLO vehicles. Once this limit is breached, managers typically have a requirement to mark their lowest-rated assets above this 7.5% figure to market.
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This rise in triple-C assets, in turn, threatens over-collateralization (OC) tests (broadly, this test requires that interest payments from assets in a vehicle pay more than the interest on its liabilities), though it does not necessarily mean a breach and failure of these tests. Typically, note analysts at S&P Global Ratings, the reinvestment OC test is the first to be breached, as it sits at the bottom of the CLO waterfall, before the payment of management fees. A general failure of the OC test, analysts explain, is caused by an increase in downgrades to triple-C, defaults, and discount obligations, as well as a decrease in the market value of triple-C assets that are part of the excess. Typically, any cure is through a repayment of the senior notes with interest payments diverted from junior-owned items.
In terms of the actual impact on European CLOs, managers of large portfolios say triple-C buckets for many of their vehicles in Europe are reaching as much as 12% of total assets, and continue to fill at unprecedented speed.
“During the last crisis the size of triple-C buckets increased each month, but now they are increasing by a couple of percentage points each week,” said one highly experienced manager. “CLOs are a fantastic product, but they are not designed to move quickly.”
One manager also notes that — dependent on the rating agency — there is a significant variance in the size of the triple-C basket across vehicles, though the direction of travel is broadly the same for S&P, Moody’s, and Fitch.
So far, one European manager is understood to have voluntarily switched off the payment of sub-fees for the April payment date, and others will follow come July, sources say. “You are going to see a lot of funds take action by the summer,” said one manager. Funds may defer their sub-fees at their own discretion, S&P Global Ratings analysts add, while pointing out that CLOs can use this saved cash for reinvestment or to purchase assets.
Technical talk
Furthermore, there is speculation that the growing bulk of lower-rated B and triple-C credits will bring technical selling from investors such as CLOs.
“This is definitely a theme, and something I think will persist as the market becomes firmer,” said one account, who also notes the trend is supporting demand for higher-rated assets. “With the majority of technical sells, the manager will be looking to balance the sell with an improving buy leg, which is why higher-quality names have been outperforming,” he adds.
Even so, accounts agree this pressure is not going to lead to a mass of secondary sales at deep discounts.
“CLOs will not be forced to sell, but demand for triple-C paper will fall further and there will be little to hold up prices,” said one account. “Most names are not yet special-situation plays.”
Managers say the sheer volume of downgrades means it makes little sense to dump paper, given the hit it would mean for par values.
“If a manager sells at 83 then it has to take the mark-to-market hit for something bought at 99 or par,” one account adds.
This reticence explains why some secondary prices have been slow to move — or are even unchanged— in response to ratings downgrades. Trading prices in U.K.-based attractions group Merlin Entertainments (Dungeons) Ltd., for example, were largely unaffected by a one-notch downgrade from Moody’s, to B2, on April 7, and indeed the firm became the first purely European name to reopen the fixed-rate high-yield market last week.
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Spectrum analysis
The effect further down the credit spectrum is also mixed, and this dynamic has resulted in names such as BMC, Diversey, GTT, and Finastra/Misys losing five or so points in the secondary loan market, amid fairly volatile moves, following recent downgrades to triple-C. In contrast, Amer Sports has moved up by around six points, into the mid-70s, since its two-notch downgrade, with a negative outlook to B3 from Moody’s on March 30, and to B- from S&P on April 7. For most CLOs, a B3/B- rating on negative outlook counts as a triple-C asset for WARF tests, but does not go into those baskets.
This unpredictable reaction to ratings moves partly reflects accounts' focus on portfolios and individual credits that are most likely to survive this crisis intact, or at the very least, that will be able to access government support schemes.
"If downgrades had come at the start of the year, then there would have undoubtedly been sudden selling pressure," said one manager. "Today, you might opt to sell if you think values are going to fall significantly further. But for most, the concern is now for the liquidity position of each name.”
David Cox covers the European leveraged finance market for LCD.
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