Broadly syndicated loan collateral loan obligations (BSL CLOs) benefit from portfolio diversification, both from an issuer and industry sector standpoint, with most BSL CLO managers maintaining highly diversified portfolios of leveraged loans with exposure to many different corporate issuers. Based on our review of third-quarter 2019 data, the average reinvesting U.S. BSL CLO portfolio rated by S&P Global Ratings had:

• An average obligor diversity metric (or effective obligor count) of 198; and
• An average industry diversity metric (or effective industry count) of 25 (see "Third-Quarter CDO Monitor Benchmarks Reveal Relative Credit Quality And Diversity Of CLO Portfolios," published Oct. 11, 2019).

Credit Quality And Loan Prices Fall As Yields Pick Up In Third-Quarter 2019

The slowdown in U.S. growth coupled with the uncertainty around the trade dispute with China has cast rainclouds over the U.S. economy, which has been especially felt in the U.S. leveraged finance market. Corporate earnings forecasts have also trended down given the uncertainties as well as increases in wage and input costs. The pressure is amplified for weaker borrowers, who have seen deterioration in their creditworthiness and experienced downgrades and dislocation in market prices.

The late-cycle credit risks are becoming more apparent with the rise in idiosyncratic stories and "one-off" credit issues around companies. The increased credit stress is evidenced by more downgrades and defaults as well as a ballooning of S&P Global Ratings' placements on negative CreditWatch and negative outlooks on companies. For 2019 year-to-date:

• U.S. corporates have seen a total of 63 defaults, surpassing the 47 defaults experienced in 2018 and 54 defaults in 2017;
• The number of U.S. issuers that have their credit ratings at 'B-' or below with ratings on a negative outlook or negative CreditWatch is at 177, portending more downgrades into the "CCC" range and defaults; and
• This count of "weakest links" is the highest this metric has been in over three years.

For our rated universe of U.S. BSL CLO transaction portfolios, we show average values over time for seven key credit metrics in table 1 (see the Appendix for calculation specifics):

• Issuer count: The obligor count across the transactions;
• SPWARF: The S&P weighted average rating Factor for the CLO collateral, with a higher value indicating a lower average rating across the transactions;
• WARR: The weighted average recovery rate for the loans in the portfolios, as implied by the corporate recovery rating we have assigned to each loan;
• WAS: The weighted average spread over LIBOR of the loans in each CLO portfolio;
• WAP: The weighted average price of the loans in each CLO portfolio based on market sources;
• Debt-to-EBITDA ratio: The average total leverage (debt/EBITDA) for the loans in each portfolio (including addbacks and other EBITDA adjustments); and,
• Interest coverage: The average interest coverage ratio for the loans in each CLO portfolio.

Table 1

• Credit quality deteriorated during Q3 2019, as reflected in the increase in SPWARF, the increase in the average debt-to-EBITDA ratio, and the decrease in the interest coverage ratio.
• The average unstressed recovery implied by our corporate recovery ratings also declined to below 64%, down by almost 1% since we began these updates.
• Loan spread has had a gradual increase over the past year, increasing by 3 basis points in Q3 2019, the largest increase since we began these updates.
• The prices of the loans in the CLO portfolios (WAP) has declined to less than 97 following trends in the broader loan market that have declined for 'B' category obligors.

SPWARF and WAS for CLO exposures have both increased in Q3 2019.

Chart 1

3% Of CLO Exposures Saw A Notable Dip In Market Value

Almost 3% of reinvesting US BSL CLO exposures saw a 10-point or greater drop in price during the third quarter, leading to the drop in overall average price from 97.15 to 96.73 in table 1.

Software is the largest Global Industry Classification Standard (GICS) sector in this sample of CLOs; however, it did not contribute much to the overall price decline. In fact, across the 114 issuers, the average price of the loans from software issuers have actually gone up since Q2.

Note that the portion of software exposure on negative outlook or CreditWatch negative (8.9%) is less than the overall CLO exposure to negative outlooks or CreditWatch negative (18.2%), as shown in chart 2. Widely held software issuer Riverbed (top 250) saw its rating lowered into the 'CCC' category in Q3, while a less widely held issuer IPC Corp saw its rating lowered to 'CC' in Q3. Both of these issuers only had mild declines in price (IPC was already trading a notable discount as of Q2).

Loans that suffered the largest price declines in Q3 are scattered across various industries ...

Table 2

Thirteen fairly widely held issuers (amongst the 750 largest exposures), scattered across 10 sectors, saw large declines (20 points or greater) in price during the quarter. Most of these issuers also suffered downgrades during this time, leading to slight deterioration to their respective sector averages.

… though there were a few "hot" spots in certain GICS sectors

CLO exposure to IT services issues (the fifth-largest GICS sector) saw negative changes in Q3 2019. Seven out of the 55 IT services issuers saw downgrades, three of which got downgraded into the 'CCC' bucket, causing the SPWARF of the IT services issuers to tick up notably this quarter. The WAP of this sector has also ticked down notably by almost 3 points on average. WARR declined while WAS increased.

Our outlook on global IT spending has worsened through 2019. We currently expect 2019 IT spending growth to be flat to a low-single-digit percentage increase due to lingering macroeconomic and trade related concerns, which have impacted business confidence and slowed investment decisions. While the situation has not yet caused a significant and widespread deterioration in the fundamentals of the tech sector, certain company-specific factors have precipitated downgrades to companies such as Riverbed Parent Inc. and Optiv Inc. We expect the slowing IT spending environment to exacerbate poor operating performance at the margin for companies with weak business prospects, and it could represent a tipping point for more downgrades of companies that are operating with very highly leveraged capital structures.

Table 3

Pharmaceuticals, currently the 17th-largest GICS industry with 15 issuers as of Q3 2019, saw large changes in SPWARF and price in Q3 due to changes within two large exposures, both within the top 250.

• Mallinckrodt International Finance S.A., a top-250 exposure, saw its ratings downgraded to 'CCC' from 'B' (due to opioid litigation risks), while prices dropped by 15 points.
• Amneal Pharmaceuticals LLC, another top-250 exposure, saw its rating downgraded to 'B' from 'BB-' (due to difficulties within the generics industry), while its loans saw a 14-point drop in price.

The U.S. generics pharma industry is certainly not in the best of health these days. Generic price deflation in the U.S. market, the largest generic drug market in the world, has hurt generic drug companies' EBITDA and cash flows, leading to higher-than-expected leverage for longer periods and contributing to negative ratings actions in the sector.

Overall, the SPWARF of the pharmaceutical sector in CLOs increased by 450, while its average price declined by 4 points on average (see "The Health Care Credit Beat: Has The U.S. Generic Pharma Sector Hit Rock Bottom?", July 31, 2019).

What's next for Q4?

Loan prices never rebounded fully after the dip at the end of last year. As we approach the end of 2019, perhaps the scrutiny around loan prices will continue. So far in the year, downgrades and market price declines have not really been focused in any particular sector. As of the end of Q3 2019, overall 'B-' exposure is about 19.0%. Of these 'B-' rated companies, 61 issuers, 2.9% of CLO exposure, have either a negative outlook or are on CreditWatch negative. 'CCC' category exposure is about 4.7%, and non-performing exposure is about 0.3%. If these weaker 'B-' issuers get downgraded, some CLOs could breach their 'CCC' triggers and experience market value haircuts in the near future.

Table 4

CLO Assets Weighted By Exposure

Weighted average metrics

We focus on the loans issued by over 1,400 corporate issuers, representing over 96% of the assets under management currently held in U.S. BSL CLOs rated by S&P Global Ratings. We calculated the average metrics for all floating-rate assets with both an S&P Global Ratings' credit rating and an S&P Global Ratings' recovery rating (the floating S&P-rated CLO assets), weighted by the dollar exposure to each asset. These metrics include the SPWARF, WARR, WAS, WAP, weighted average debt-to-EBIDTA ratio, and weighted average interest coverage (see table 1 above). (See the Appendix for detailed explanations of the scope for this study and the metrics.)

The SPWARF of the S&P-rated CLO assets of 2,640 is higher than the SPWARF of the top 250 list, which was 2,451 as of third-quarter 2019 (see "The Most Widely Referenced Corporate Obligors In Rated U.S. BSL CLOs: Third-Quarter 2019," published Oct. 9, 2019). The lower credit quality of the more than 1,000 smaller and less-widely held issuers has caused the overall SPWARF to be higher. The top 250 list represent the most widely held issuers in CLOs, and they generally consist of the largest issuers, which happen to have higher ratings.

Average metrics per industry

We observed that the corporate issuers operating within various industries have different credit profiles. The loans they issue also have different characteristics. Using CLO exposures to these floating S&P-rated CLO assets, we calculated the average metrics described in the Appendix, weighted by par, across the various GICS sectors.

Table 5

Ratings bias per GICS sector

At the end of the second quarter, 18.2% of the floating S&P-rated CLO assets had a negative rating bias, down slightly from the 19.4% at the start of the year. The breakdown between negative bias, positive bias, and stable for the top 30 GICS sectors is listed in table 4, each weighted by dollar exposure. The bias breakdown per GICS sector is highly sensitive to the rating bias of the issuers with higher CLO exposure, particularly the GICS sectors with less obligors.

Chart 2

Appendix

The scope: floating S&P-rated CLO assets represent 96% of assets under management in reinvesting U.S. BSL CLOS

The information is based on the aggregation of CLO exposures to corporate issuers as reported in third-quarter 2019 trustee reports of reinvesting U.S. CLOs of BSLs.

S&P Global Ratings' corporate group issues and maintains credit ratings for the vast majority of companies that issue the loans held in CLOs. As part of our credit rating process, we capture various ratios of the issuer at the time of the rating. We also issue and maintain recovery ratings for the vast majority of loans held in CLOs.

Almost all of the companies that issue loans held in U.S. CLOs are classified within the GICS. These industry classifications are utilized within the CDO Evaluator credit model, which is used by the S&P Global Ratings structured finance group's rating process for CLOs.

We aggregate CLO exposures reported in trustee reports available as of the end of third-quarter 2019 and calculate various metrics, weighted by the outstanding par amount of exposures and stratified by the GICS classification of the issuer of the loans. We focused on the floating-rate assets with both an S&P Global Ratings' credit rating and an S&P Global Ratings' recovery rating (the floating S&P-rated CLO assets). These floating S&P-rated CLO assets were issued by more than 1,400 corporate issuers operating across 66 GICS industries and represent over 96% of the total par of the CLOs aggregated in this third-quarter 2019 update. The credit rating, recovery rating, spread, price, and leverage ratio values of these floating S&P-rated CLO assets were used to calculate the averages outlined in table 3.

The metrics

S&P Global Ratings' weighted average rating factor (SPWARF) 

The SPWARF of a CLO portfolio provides an indication of the overall credit rating distribution of the portfolio, weighted by each assets par balance. The rating factor for each of the portfolio assets is determined by S&P Global Rating's credit rating (or implied rating) and the rating factor. (The S&P Global Ratings' rating factor of an individual asset is the five-year default rate given its S&P Global Ratings' credit rating and the default table in the corporate CDO criteria, multiplied by 10,000.) The SPWARF is calculated by multiplying the par balance of each collateral obligation by the S&P Global Ratings rating factor then summing the total for the portfolio and dividing this result by the aggregate principal balance of the collateral obligations included in the calculation.

Weighted average debt-to-EBITDA ratio (WA debt-to-EBITDA ratio) 

The leverage is based on the assumptions we make around debt and EBITDA, as used in our rating analysis.

• Debt: For the purpose of debt, we include items such as leases (both capital and operating), preferred shares, and accrued dividends.
• EBITDA: Our analysis generally adheres to what earnings before interest, taxes, depreciation, and amortization). That is, revenue minus operating expenses plus depreciation and amortization (including noncurrent asset impairment and asset reversal).

Beyond that definition, our decision to include or exclude an activity from EBITDA depends on whether we consider that activity to be operating or non-operating.

Examples of income statement activities classified as operating that are included in our EBITDA calculation are:

• Restructuring costs;
• Acquisition-related costs; and
• Interest and depreciation of lease-related expenses.

Examples of income statement activities excluded from our EBITDA calculation are:

• Disposals;
• Long-life asset impairments/write-downs; and
• Nonrecurring items.

For a subset of assets with an S&P Global Ratings' credit rating, the WA debt-to-EBITDA ratio is the sum product of each issuer's debt-to-EBITDA ratio at the time of the rating action and the par exposure of the issuer's debt as a percentage of the sum of the par of the subset of assets.

Weighted average EBITDA interest coverage (WA interest coverage) 

For entities with weaker leverage assessments, interest coverage ratios can also shed light into the issuer's ability to service its debt.

We use the EBITDA value, as described above, divided by the carrying cost, or interest burden of the issuer's debt.

For a subset of assets with an S&P Global Ratings' credit rating, the weighted average EBITDA interest coverage is the sum product of each issuer's EBITDA interest coverage ratio at the time of the rating action and the par exposure of the issuer's debt as a percentage of the sum of the par of the subset of assets.

Weighted average recovery rate (WARR) 

For a subset of assets with an S&P Global Ratings' recovery rating, the WARR is the sum product of each asset's recovery rate (the number within parenthesis to the right of the recovery rating) and the asset's par exposure as a percentage of the sum of the par of the subset of assets. For more details on S&P Global Ratings' recovery ratings, see "Recovery Rating Criteria For Speculative-Grade Corporate Issuers," published Dec. 7, 2016.

Weighted average spread (WAS)  

For a subset of floating-rate assets, the WAS is the sum product of each asset's nominal spread above the base rate and the asset's par exposure as a percentage of the sum of the par of the subset of assets.

Weighted average price (WAP) 

For a subset of assets with loan prices, the WAP is the sum product of each asset's price at the end of the quarter and the asset's par exposure as a percentage of the sum of the par of the subset of assets.

Data coverage of the floating S&P-rated CLO assets listed in table 3 

Because we focus only on floating S&P-rated CLO assets (worth over 96% of the overall assets under management in the sample), by definition, we have full coverage of the data used to calculate the SPWARF, WARR, and WAS in table 3. We have credit ratings, recovery ratings, and spread information for all loans issued by the over 1,400 issuers.

Due to limitations within the various data sources, we did not have complete coverage regarding the price and leverage ratios for all the loans issued by the over 1,400 issuers. We had pricing information for over 99% of the loans and corporate leverage ratio information for 84% of the loans. The WAP, WA debt-to-EBITDA ratio, and WA interest coverage values are the weighted average values of the loans for which pricing and leverage ratio data are available.