S&P Global Ratings did not take any rating actions on tranches from reinvesting U.S. broadly syndicated loan (BSL) collateralized loan obligations (CLOs) during the fourth quarter of 2019. We did, however, downgrade our ratings on 21 classes of mezzanine and junior notes, mostly from older vintage CLO 2.0s in the latter part of 2019, see "63 U.S. CLO Ratings Raised, 21 Lowered, And 266 Affirmed After June 2019 UCO Placements Resolved," published Dec. 18, 2019). Credit deterioration and par loss in CLOs mostly stemmed from credit deterioration and rating actions taken on corporate entities that issued loans collateralizing these CLOs. Negative rating actions on the loan issuers can directly affect both a CLO's portfolio credit quality as well as its structure (through overcollateralization [O/C] tests and other tests). Given the increased investor attention to the performance of the underlying entities of CLOs in this late credit cycle, and the potential consequences for CLOs, we are launching this quarterly publication to provide further insights into these corporate rating actions as well as the exposures CLO managers have to these downgraded and upgraded issuers across their reinvesting CLOs. Because reinvesting CLOs are actively managed structures, there can be a high degree of variance between transactions based on the CLO managers' strategy.

Fourth-Quarter 2019: The Issuer Rating Experience

Ninety-three issuers with loans held in reinvesting S&P-rated U.S. BSL CLOs ended fourth-quarter 2019 with ratings that were lower than they were at the start of the quarter, while 29 issuers ended the quarter with ratings that were higher (full list appended in tables 2 and 3 in the Appendix). The range of the rating actions affected on the underlying entities between the start and end of fourth-quarter 2019 spanned minus four notches to plus five notches. The rating changes, both positive and negative, ranged between widely held issuers (within top 250 list) to thinly held issuers, and across a wide range of industries.

CLO Market Participants Wary Of Downgrades Into 'CCC' Range And Nonperforming Category

For CLO market participants, the downgrade of issuers into the 'CCC' ('CCC+', 'CCC', 'CCC-') and nonperforming rating categories ('CC', 'SD', 'D') is of "notable" concern on account of the potential impact to payment waterfall sequences arising from the haircuts applied to the O/C numerator (see CLO primer "S&P Global Ratings' CLO Primer," published Sept. 21, 2018, for the mechanics of the O/C test).

In the fourth quarter, the U.S. CLO index (see "SF Credit Brief: Wrap Up Of 2019 U.S. CLO," published Jan. 29, 2019, and our CLO Insights newsletter) experienced a favorable 32 basis point (bp) decline in 'CCC' exposure (to 4.64% from 4.97%), an adverse 39 bp increase in nonperforming loans (to 0.67% from 0.28%), along with an adverse 13 bp decline in par (to 29 bp from 15 bp, relative to the par balance at the start of 2019). As a result of these net changes, the cushion of the junior O/C tests declined by 46 bps during this time to the lowest point in 2019 (to 3.69% from 4.14%). Some deals within this index were close to failing their junior O/C tests at the end of 2019.

Some of the widely held names that saw their 'CCC' category ratings lowered to nonperforming include McDermott and Murray Energy (which were the 76th- and 177th-largest CLO holdings, respectively, at the end of the third-quarter 2019 and 95th and 192nd, respectively, by the end of fourth quarter 2019). Widespread exposure to these companies caused a decline in the average 'CCC' holdings and an increase in average exposure to nonperforming, as noted above. There weren't many widely held names that were downgraded into the 'CCC' category (another reason for the overall decline in the 'CCC' category exposure in fourth-quarter 2019), but some of the less widely held names like Southern Graphics, Gulf Finance, and Rodan & Fields did get downgraded into the 'CCC' category. There were several issuers that saw their ratings lowered to 'B-'; some of the widely held issuers include Neustar Inc. (Aerial Parent Corp.), Boxer (Banff Parent Inc.), Team Health, and Proampac.

By the end of fourth-quarter 2019, 12 issuers saw their ratings lowered into the 'CCC' category, while nine issuers saw their ratings lowered into the nonperforming category (from 'CCC-' or above), the "notable" downgrades. Just a few sparsely held issuers saw their ratings raised out of the 'CCC' and nonperforming categories, so the positive impact from these upgrades were far less pronounced than the negative impact from the downgrades. To help illustrate the variance across manager exposures to the "notable" downgrades, see chart 1. We list 18 CLO managers that manage eight or more reinvesting S&P-rated U.S. BSL CLOs (see table 4 below for the exposures to downgrades and upgrades across 81 managers). The chart below shows the level of manager exposures (across their CLOs as of third-quarter 2019) to the issuers that saw their ratings lowered into the 'CCC' and nonperforming categories by the end of fourth-quarter 2019 (the width of the connecting lines indicate the overall volume of exposure across the portfolios per CLO manager).

Chart 1

Ratings entering into 'CCC' and below category saw notable drops in price

The price of loans to issuers that ended fourth-quarter 2019 with a lower rating also saw a drop in prices during the quarter (see table 1A above). While we don't know for certain, selling after the downgrade may have led to a drop in par for the portfolios (as noted above, the average drop in par in fourth-quarter 2019 was about 13 bp amongst the portfolios in the CLO Insights index). As expected, ratings that enter the 'CCC' or nonperforming categories in fourth-quarter 2019 saw notable drops in price, likely due to a decrease in demand from other CLOs (due to potential O/C haircut implications).

Even though 'B-' issuer exposure (if not on Watch Negative) generally does not have O/C haircut implications, market prices for loans from issuers that were downgraded to 'B-' in fourth-quarter 2019 suffered an average drop in price of about 2.8. There is a wide range of prices for loans from 'B-' rated issuers (which currently make up about one fifth of overall US BSL CLO exposures). This is especially true for loans whose issuers were downgraded to 'B-', as opposed to loans whose issuers were initially rated 'B-'.

Corporate Considerations

One feature of the corporate ratings landscape over the last couple of years has been the large volume of newly rated 'B-' issuers, many of whose loans have ended up in CLOs, along with those of 'B-' issuers that were downgraded to that rating level.

As we noted last month, companies in this "newbie" 'B' rating bucket voluntarily stomach more debt at low borrowing costs to quickly scale up; in other words, they often sell a growth story. On the other side, existing 'B-' rated companies, especially those that landed in 'B-' from a higher rating, are more likely to face ongoing secular headwinds or experience individual operating challenges, momentum that could depress a company's margins or impair its ability to make necessary investment to sustain margins. The old saying that "there is no such thing as one bad quarter" could explain the focus on new versus newly downgraded 'B-'.

Pulling the (downgrade) trigger

In looking at how close certain 'B-/Stable' and 'B-/Negative' (or Watch Negative) credits are to their downgrade triggers, we see that not all have traditional downgrade triggers tied to the "Big 3" (debt to EBITDA, EBIT to interest coverage, and funds from operations to debt). For example, it's not uncommon for a downgrade trigger to the 'CCC' category to include the concept of an unstainable capital structure or a liquidity metric.

As such, we looked at issuers as of year-end 2019 that have some or all of those "Big 3" triggers. We focused in particular on debt-to-EBITDA triggers since that was the most common credit metric when one was used. While this sample size is far smaller than all 'B-' credits, we believe it provides some interesting insights (some of these companies have had rating actions taken subsequently).

About 60% of the sample of issuers rated 'B-/Negative' (or Watch Negative) are at or very close to their downgrade triggers with very limited room (other factors such liquidity or non-quantitative metrics could also play a role in any downgrade decision), while another 10% have what we termed tight cushion to the leverage trigger: between one and two turns of leverage. Another roughly 30% have modest cushion, or about 2x-3x of leverage cushion or better (see chart 2).

Chart 2

Looking at the 'B-/Stable' cohort, it's clear that relative to downgrade metrics, these issuers have more cushion: 29% have two turns of leverage or more, but 37% have very limited room for error (see chart 3).

Chart 3

Another way to think about the 'CCC' pipeline from the 'B' category is to consider what would happen if all 'B-/Negative' (or Watch Negative) borrowers were downgraded to the 'CCC' category. In this case, the 'CCC' category percentage of the universe of 'B-' and below would rise sharply and be about equal to the roughly 46% level reached during the financial crisis.

What's On Deck For Potential Default?

It's important to remember that CLO exposure to various corporate sectors is a manager choice (within transaction parameters), and does not necessarily reflect an equally diversified and sectorally distributed portfolio. That said, the potential for defaults across industries is driven more by sectoral stress, and thus is not uniform as some 60% of defaults in 2019 were from the consumer products; the metals, mining, and steel; the oil and gas; and the retail and restaurants sectors (see chart 4). Therefore, we believe CLO investors should pay close attention to both sides of the equation: the individual corporate sector risks, especially the 'B-' and 'CCC' buckets, as well as CLO exposures to certain issuers.

Chart 4

Appendix

Table 2

Table 3

Table 4

In tables 2 and 3, we focused on the third-quarter 2019 portfolio exposures across 421 reinvesting S&P-rated U.S. BSL CLOs in this survey. In table 4, we list overall exposure to the issuers listed in tables 2 and 3, per manager across the S&P-rated CLOs that they manage (we aggregate the CLO portfolios from managers together to calculate their exposures in table 4). We created these tables based only on S&P-rated portfolios per manager (we include the count CLOs used to calculate the exposures in table 4). At a high level, we expect managers to generally have a high degree of overlap between their deals, even for the deals we don't rate.

Managers may have sold off their downgraded exposures before or after the downgrade (on average, there was a slight decline in exposure to these downgraded names by the end of the fourth-quarter 2019 as well as some par loss, suggesting there may have been some sales of these loans at lower prices), while some managers may have increased exposure to these issuers due to attractive price levels or debtor-in-possession-like investments; however, on average, the managers maintained similar exposures to the issuers in tables 2 and 3 at the beginning and end of fourth-quarter 2019.

Related Research

• Leveraged Finance & CLOs Uncovered: https://www.spglobal.com/ratings/en/research-insights/topics/leveraged-finance-clos-uncovered
• It's Another Brick In The Debt Wall For U.S. Oil And Gas Companies, Jan. 28, 2020
• U.S. Leveraged Finance Q4 2019 Update: It's All About The Newbies, The New 'B's, Jan. 27, 2020
• As The 'B-' Universe Expands, Timing Is Everything, Dec. 6, 2019
• CLO Spotlight: To 'B-' Or Not To 'B-'? A CLO Scenario Analysis In Three Acts, Nov. 26, 2019