Eighteen new European CLO transactions priced in third-quarter 2019, adding a €7.43 billion of supply to the €14.72 billion from 35 transactions in first-half 2019. Total issuance to date stands at €29 billion across 70 CLO transactions, up from €27.3 billion from 66 transactions over the same period last year.

In this quarterly index publication, we take a look at some of the key metrics behind our ratings on the CLO notes. A month-to-month negative performance of these parameters could pressure the ratings on the notes.

New Managers Entered Market, Spreads Tightened In Third Quarter

Three new managers joined the CLO market in the third quarter, with Angelo Gordon & Co., MacKay Shields Europe Investment Management, and Capital Four CLO Management launching their debut European CLOs. While not a debut CLO 2.0 manager, NIBC also priced the first fully environmental, social, and governance (ESG)-compliant CLO with MUFG, which was the arranger's first CLO 2.0 transaction in Europe. The collateral manager will utilize and apply its own ESG industry category and scoring methodology to each collateral obligation it purchases in accordance with its ESG due diligence procedures and best practices. Its objective is to maintain a minimum ESG score on a weighted-average basis, although failure to reach or maintain this score will not result in a breach of the collateral manager's duties or obligations under the transaction documents.

'AAA' CLO spreads continued to tighten, reaching as low as 90 basis points, although signs indicate spreads could widen toward year-end. More challenging is the junior mezzanine tranches, for which spreads continue to widen, increasing the weighted average cost of capital. This in turn has led to the re-introduction of a feature more commonly seen in CLO 1.0 transactions: the turbo redemption. For a description of how it works, see the following link: https://www.spglobal.com/ratings/en/research-insights/videos/2019-12-11-clo-simplified-turbo-redemption

To 'B-' Or Not To 'B-'?

Fundamental concerns related to assets' credit quality and scarcity and challenging arbitrage continue to persist. We expect the 12-month trailing default rate for speculative-grade European corporate issuers to increase to 2.8% by June 2020, from 2.3% in June 2019. We note that the forecast is still below the long-term average default rate of 3.1% and that the economic environment continues to benefit from favorable funding conditions (see "The European Speculative-Grade Corporate Default Rate Is Expected To Reach 2.8% By June 2020," published Sept. 30, 2019). A recent area of particular concern has been the increasing shift of distribution toward lower ratings (see "To 'B-' Or Not To 'B-'? A CLO Scenario Analysis In Three Acts," published Nov. 26, 2019).

In Europe, the Middle East, and Africa, the proportion of speculative-grade issuers rated 'B-' has increased to almost 18% from 9% between last-quarter 2013 and third-quarter 2019, which has been largely due to new issuers being rated 'B-' rather than solely due to existing issuers' deteriorating credit quality. This change in rating distribution is also reflected in the concentration of 'B-' rated assets held in European CLOs, which has increased to 18% from 4% on average during the same period, which may reflect the different strategies held by collateral managers.

Chart 1

As the corporate rating actions table in the appendix section shows, in third-quarter 2019, we downgraded five issuers to the 'CCC' category, four from 'B-' and one from 'B'. Nevertheless, CLO exposure to 'CCC' rated assets remains low and significantly below the typical 7.5% limit in transaction documentation. Exposure over this limit is carried at a haircut for the purpose of the overcollateralization (O/C) test so that it breaches quicker and, in times of stress, diverts interest to deleverage the most-senior tranche.

Chart 2

Measuring CLO Performance Using Key Metrics

CLO issuance has gained momentum over the past five years, and investors have become more familiar with CLO structures and the associated risks, as well as assessing and suitably measuring credit and cash flow risks.

Credit risk, which includes default risk and an increase in 'CCC' category-rated assets in the portfolio, among others, can be mitigated by better measures on the cash flow side, like increased available credit enhancement, weighted-average spread, and recoveries, for example.

In this article, we display how these individual parameters have evolved over the last few months to broadly gauge the performance of European CLOs.

CLO Performance Remained Stable Across Key Metrics

Overall, CLO performance in third-quarter 2019 was similar to the previous three quarters. Most of the metrics we capture that may affect ratings on the notes showed stable performance.

Collateral portfolios of older vintage cohorts are becoming more concentrated as the assets wind down and they approach their final maturities, while newer vintages are benefiting from still being in their reinvestment phases, when collateral managers can actively mitigate default risk through active trading. We attribute these trends more to the stage in a transaction's life cycle than to significant changes in the portfolios at the collateral level.

Credit Metrics

European CLO 2.0 collateral ratings

While CLOs enjoy the senior secured status of leveraged loans in the portfolio, it is important to note that these loans are issued to speculative-grade companies.

Underlying collateral ratings contribute significantly to the ratings on transactions that have closed since January 2013. Below we show the rating distribution of the CLO collateral portfolio for the different vintages in European CLO 2.0 transactions over a one-year period (see charts 3 to 8). Note that we have considered transactions that have been reset or refinanced to be in the original vintage as when it was first issued. The CLO portfolio rating performance across all CLO vintages indicates stable performance.

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Chart 8

Exposure to 'CCC' rated assets continues to be well below the allowable limits

'CCC' category-rated assets are an important measure of European CLO performance because an increase in these assets can indicate that the collateral portfolio's credit quality is worsening. The level of 'CCC' assets can also reduce O/C test cushions because they may not be carried at their full par value.

The percentage of assets rated in the 'CCC' category ('CCC+', 'CCC', or 'CCC-') has shown mixed performance for the European CLO cohorts we track. These changes reflect rating migration in the underlying portfolios and may also depend on an individual transaction's pool composition, which is based on the CLO manager's strategy to manage the vehicle.

By vintage, the reported level of 'CCC' rated assets in European cash flow CLOs, as a percentage of total assets in August 2019, was:

• 2013 vintage CLOs: 0.82% of total assets (down from 1.08% in May 2019);
• 2014 vintage CLOs: 1.13% of total assets (down from 1.27% in May 2019);
• 2015 vintage CLOs: 1.61% of total assets (down from 1.64% in May 2019);
• 2016 vintage CLOs: 0.84% of total assets (down from 0.92% in May 2019);
• 2017 vintage CLOs: 0.91% of total assets (up from 0.88% in May 2019); and
• 2018 vintage CLOs: 0.99% of total assets (up from 0.85% in May 2019).

Chart 9

Individual CLOs exhibited some variances among European CLOs from the same vintages. These CLOs are more likely to breach their thresholds sooner than other types of CLOs. Having said that, in this low interest rate and benign default environment, having a 'CCC' rated asset may not necessarily be negative, because cost of debt and equity return can be better managed.

Exposure to defaulted assets remains limited

CLOs performed well through the financial crisis and beyond. Defaulted assets were one of the key indicators of CLO performance because a defaulted asset may result in a loss of principal to the CLO and a corresponding decline in credit enhancement.

From May 2019 to August 2019, the percentage of defaulted assets (i.e., assets from obligors rated 'CC', 'C', 'SD' [selective default], or 'D') slightly increased for the 2013, 2015, 2016, 2017, and 2018 vintages, and decreased for the 2014 cohort.

As of August 2019, the percentage of defaulted assets in each underlying collateral portfolio was:

• 2013 vintage CLOs: 0.46% of total assets (up from 0.25% in May 2019);
• 2014 vintage CLOs: 0.15% of total assets (down from 0.37% in May 2019);
• 2015 vintage CLOs: 0.34% of total assets (up from 0.18% in May 2019);
• 2016 vintage CLOs: 0.14% of total assets (up from 0.02% in May 2019);
• 2017 vintage CLOs: 0.10% of total assets (up from 0.05% in May 2019); and
• 2018 vintage CLOs: 0.07% of total assets (up from 0.04% in May 2019).

These calculations show the proportion of assets that are currently in default, over total assets (not including principal cash).

Chart 10

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

Although CLOs are generally restricted to eligibility criteria that govern what assets can be part of their portfolios and set their limitations, it is challenging to size a portfolio's default risk during the typical four-year reinvestment period in which the collateral manager is allowed to actively trade assets. These trading activities could change the asset portfolio's composition significantly, thus increasing its risk profile and possibly the required par subordination.

The SPWARF provides an indication of the portfolio's overall credit quality. It is each asset's five-year default rate assumed in our corporate collateralized debt obligation (CDO) criteria, weighted by each asset's par balance, and multiplied by 10,000 (see the "Related Criteria" and "Related Research" sections).

In third-quarter 2019, the overall SPWARF reduced from 2,626 to 2,610.

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Weighted-average life (WAL) decreased

The WAL is the number of years between the current date and the maturity date of assets in the CLO portfolio.

At 5.1, the WAL is decreasing quarter on quarter.

Chart 12

Scenario default rates (SDRs) improved

Together with the SPWARF and WAL, we use four other benchmarks (the three diversity measures and the default rate dispersion [DRD]) to produce the approximate 'AAA' SDR (i.e., the expected default levels for the portfolio under the 'AAA' stress scenarios).

While the SPWARF only looks at the credit rating on the assets, SDRs (or the expected target default rate) look into all six components when measuring the overall risk profile of a CLO portfolio (SPWARF + DRD + WAL + the three diversity measures).

On average, the current portfolio credit risk ('AAA' SDRs) has improved in comparison with second-quarter 2019, decreasing to 61.05% from 63.85%.

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Cash Flow Metrics

Credit enhancement has remained steady

Our analysis of CDO transactions, as in our other structured finance ratings, focuses on how much credit enhancement is needed for a given level of credit risk to achieve a specific rating. Typically, credit enhancement is provided by a combination of overcollateralization/subordination and cash collateral. In this case, credit enhancement is the percentage of total performing assets plus cash, minus the tranche balance (including senior and pari passu note balance), divided by total performing assets, plus cash plus recovery on defaulted assets. The credit enhancement levels across the capital structure remained stable over 2018 and 2019.

Table 1

Weighted-average spread followed recent quarterly trends

Spreads vary based on a variety of factors, including the levels of relative liquidity for leveraged loans or the actual and perceived level of credit risk in the leveraged loan market, among others.

Over the past two to three years, leveraged loans have refinanced at a lower cost, leading to increased difficulty in managing the weighted-average spread test in CLOs and in maintaining the weighted-average cost of debt and a healthy return to equity. Consequently, weighted-average spreads are monitored closely in CLOs. If this measure decreases significantly, the risk of a negative rating action on the notes would increase.

On average, the weighted-average spread has remained stable over the past three quarters, which has helped CLO managers manage their weighted-average spread tests.

Chart 14

Senior O/C ratios showed some improvement

The senior O/C ratio test is a par value test to protect senior noteholders. Declines in the senior O/C ratio test results can indicate decreasing credit quality of the CLO. The O/C ratio is the difference between the O/C test calculated for a particular tranche and the trigger associated with it. Breach of these triggers will mean that senior notes are repaid (until the tests are met again), or if the transaction is in its reinvestment period, the proceeds due on junior notes are either invested in substitute collateral or used to repay the notes.

The senior O/C ratio test cushions improved from May 2019 to August 2019 for all the cohorts (see chart 15).

The senior O/C ratio test cushions (based on reported information) as of August 2019 were:

• 2013 vintage CLOs: 9.25% (up from 8.53% in May 2019);
• 2014 vintage CLOs: 10.70% (up from 9.69% in May 2019);
• 2015 vintage CLOs: 9.13% (up from 8.89% in May 2019);
• 2016 vintage CLOs: 9.87% (up from 9.76% in May 2019);
• 2017 vintage CLOs: 9.61% (up from 9.53% in May 2019); and
• 2018 vintage CLOs: 9.57% (up from 9.03% in May 2019).

Chart 15

Subordinated O/C ratios picked up slightly

The subordinated O/C ratio test is the par value test for the junior notes in the CLO. Failure to satisfy this test will typically cause interest and principal to be redirected to pay down the most-senior class of notes until the test is satisfied.

From May 2019 to August 2019, the subordinated O/C ratios showed slightly improved performance for all of the CLO 2.0 vintages we track (see chart 16).

As of August 2019, the subordinated O/C ratio test cushions (based on reported information) were:

• 2013 vintage CLOs: 3.85% (up from 3.47% in May 2019);
• 2014 vintage CLOs: 3.80% (up from 3.65% in May 2019);
• 2015 vintage CLOs: 3.86% (up from 3.76% in May 2019);
• 2016 vintage CLOs: 4.65% (up from 4.39% in May 2019);
• 2017 vintage CLOs: 4.28% (unchanged from 4.28% in May 2019); and
• 2018 vintage CLOs: 4.40% (up from 4.30% in May 2019).

Chart 16

Notes

Our European CLO Performance Index Report provides aggregate performance statistics across most of our rated European cash flow CLO transactions backed primarily by corporate loans. We provide this information to help market participants track the overall performance of European cash flow CLO transactions and to benchmark the performance of the transactions they follow against the performance of cohorts of similar transactions.

Our report highlights what we view as a number of key risk areas for the transactions, and which we use as part of our analysis of the credit quality of securitized portfolios and of the transactions' payment structure and cash flow mechanics. These include rating migration within the underlying collateral portfolios, as well as other information relevant to the sector.

We divide the performance information in the CLO indexes into cohorts, each containing data for most of the European CLO transactions we rated and issued in a specific vintage year. We collect the performance information from transaction-level performance data in our CDO surveillance databases.

Information prior to the most recent 12 months is available on CDO Interface, S&P Global Ratings' web-based portal for CDO performance information, at www.cdointerface.com. To generate, view, and download data from the CDO indexes, log onto CDO Interface, and then select the "Indexes" tab.

Appendix

Appendix 1

Appendix 2

Related Criteria

• Global Methodology And Assumptions For CLOs And Corporate CDOs, June 21, 2019

Related Research

• Presale: North Westerly CLO VI B.V., Nov. 19, 2019
• CLO Spotlight: Third-Quarter CDO Monitor Benchmarks Reveal Relative Credit Quality And Diversity Of CLO Portfolios, Oct. 11, 2019
• The European Speculative-Grade Corporate Default Rate Is Expected To Reach 2.8% By June 2020, Sept. 30, 2019
• Credit FAQ: Understanding S&P Global Ratings' Updated CLO And Corporate CDO Criteria, June 26, 2019
• S&P Global Ratings' Updated Assumptions For CDO Monitor Non-Model Version, June 21, 2019
• 2018 Annual Global Leveraged Loan CLO Default And Rating Transition Study, June 19, 2019
• A Cycle Turn Will Test European CLO 2.0 Defaults, June 7, 2019
• European CLOs: Lack Of Loan Supply Is Causing Further Portfolio Overlap, May 30, 2019
• Glossary Of Cash Flow CLO Performance Index Fields, Jan. 30, 2009