At the beginning of 2020, the European collateralized loan obligation (CLO) market was facing several challenges, including credit deterioration, difficult arbitrage conditions, and asset scarcity. CLO investor concerns were typically over corporate credit deterioration and leverage ratios, expected recoveries, and loose documentation. At the macro level, trade wars, Brexit, and extended low rates were among the top risks. In spite of these concerns, CLO issuance started strongly, with several new transactions and senior note spreads dipping to a 20 month low. However, the sudden economic stop caused by the spread of COVID-19 and related containment measures will lead to a global recession, in S&P Global Ratings' view.

We expect a surge in the European speculative-grade corporate default rate to the high single digits over the next 12 months, although the severity will vary significantly by sector and individual credit characteristics. As a result, there could also be an impact on CLOs, which are securities backed by a portfolio of corporate debt, typically senior secured loans made to speculative-grade companies, whose average credit rating is in the 'B' ('B+', 'B', and 'B-') category.

Economic Downturn Set To Pressure EMEA Corporate Ratings

COVID-19 is one of the key challenges the European leveraged loan and CLO market will face in 2020. S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak between June and August, and we are using this assumption in assessing the economic and credit implications. We believe measures to contain COVID-19 have pushed the global economy into recession and could hurt employment levels and housing markets (see our macroeconomic and credit updates here: www.spglobal.com/ratings. As the situation evolves, we will update our assumptions and estimates accordingly.

Although economic data is currently limited, our short-term macroeconomic outlook for Europe has deteriorated and we now expect a contraction in Eurozone GDP of 0.5%-1.0% in 2020, revised down from our previous forecast of 0.5% growth. COVID-19 related disruption will affect economic activity in the first half of the year, with a particularly severe hit in the second quarter as near-lockdown measures adopted across Europe dampen the real economy.

The combined effect of COVID-19, with the collapse in oil prices and extreme volatility in capital markets will inevitably have severe implications for credit. In our view, this will likely mean a surge in defaults, with the speculative-grade corporate default rate potentially increasing to the high single digits in Europe over the next six to 12 months from a base case of 2.3%.

The sharp decline in global demand will reduce corporate cash flow generation across industries, placing pressure on working capital needs, available cash, and revolving facilities, as well as companies' ability to remain operational. Government-led fiscal support for companies (especially smaller ones) will offer an alternative avenue for liquidity in the absence of constructive primary capital markets.

Nevertheless, the impact of the COVID-19 disruption will not be uniform across all industries. Sectors exposed to people mobility and discretionary spending, such as airlines, transportation, leisure and gaming, hotels and restaurants, and retail, are likely to be affected the most. Exposure and reliance on cross-border supply chains is another pressure point weighing on the overall creditworthiness of auto manufacturing and capital goods, for example. We expect credits in the healthcare, software, and telecommunication sectors to be more insulated.

Recent oil price shocks add yet another dimension in assessing vulnerabilities. Though oil at less than $35 per barrel will alleviate the variable cost component of issuers in the chemicals sector, this is likely to be more than offset by top-line contraction and high fixed cost component.

Companies rated 'B-' and below will likely suffer most from financing needs and rapid rating transitions. These companies are most likely to lack the financial flexibility to weather a crisis hitting both their top-line revenue and financing costs. They are also the most exposed to risks of distressed exchange or debt restructuring, which would qualify as a default under our ratings definitions.

Having access to ample liquidity to withstand at least two to three months of severely reduced revenue inflows, a nimble cost base, and access to liquidity will be key. We expect a deluge of covenant waiver and covenant reset requests, additional revolving credit facilities made available to cover working capital and cost shortfalls, and swift and severe cost cutting measures, culminating in distressed exchanges and even forced restructurings. There may also be isolated insolvency cases with limited recovery prospects where emergence as a going concern may not be feasible, particularly for smaller issuers.

So Far, Minimal EMEA CLO Exposure To Downgraded Credits

As of March 25, 2020, we have taken negative rating actions on 208 U.S. and EMEA speculative-grade corporate issuers, to which European CLOs are exposed, for reasons related to the spread of COVID-19, including downgrades, and negative outlook and CreditWatch placements (see tables 1 and 2). On aggregate, these credits are included in the portfolios of 110 European CLOs that we rate, but account for only 7% of the total portfolio exposure by notional amount.

Chart 1

Table 1

Table 2

Chart 2

In aggregate, the universe of European CLOs that we rate is generally well-diversified by issuer, country, and sector, with more than 600 issuers across 27 countries and 60 Global Industry Classification Standard (GICS) industries (see table 3).

Industries reliant on consumer discretionary spending (e.g., travel and high-end retail) and cross-border supply chains (e.g., auto, electronics, and chemicals) are particularly exposed to COVID-19 related risks and will see increased pressure on revenue and earnings (see "Global Credit Conditions: COVID-19's Darkening Shadow," published March 3, 2020).

Table 3

Chart 3

Overall CLO performance in fourth-quarter 2019 showed slight credit deterioration compared with the previous three quarters, with an increase in 'CCC' category rated assets, and a worsening of the S&P Global Ratings weighted-average rating factor (SPWARF) and scenario default rates (see "European CLO Performance Index Report Q4 2019," published on March 24, 2020). Most of the other metrics we capture showed stable performance.

Chart 4 shows the CLO exposure by loan amounts per country broken down by current outlook. It also indicates the percentage of exposure amount for that country that has been affected by a COVID-19 related rating action out of the total country exposure.

Chart 4

Effect On European CLO Tranches

Considering the speculative-grade corporate rating actions that we have taken since the emergence of COVID-19, several of the affected credits are not present in the portfolios of any European CLOs that we rate. In addition, 25% of the credits with rating actions had their outlook changed to negative, which alone would not alter our credit analysis of CLO portfolios. By contrast, 56% had their rating placed on CreditWatch negative, which our CLO credit analysis treats as a one-notch downgrade.

That said, CLOs benefit from structural features such excess spread, tranching, and the deferability of coupon payments on the mezzanine and junior notes. These factors make CLOs relatively resilient structures, and an increase in corporate downgrades is unlikely to lead to any CLO tranche defaults in the short term. A more likely scenario is that speculative-grade CLO tranches (and possibly some tranches originally rated 'BBB') could be downgraded.

The likely increase in the number of assets falling into the 'CCC' rating category has two effects. First, our stressed scenario default rates for the portfolio would increase, although not significantly. Second, there could also be a breach of the portfolio's documented 'CCC' limit, which could ultimately lead to a breach of coverage ratios. This would mean funds being diverted to repay the senior notes, increasing the CLO's average cost of debt and reducing excess spread.

For example, let's consider a 'AAA' rated CLO tranche, with 38.5% credit enhancement, and an assumed portfolio default rate of 65% in a 'AAA' stress (the scenario default rate; SDR). In general, an increase of 'CCC' category rated assets to 5% is unlikely to cause a downgrade, based on our credit and cash flow models. Similarly, an increase of 'CCC' category rated assets to 15% would increase the SDR by about 2.3 percentage points at the 'AAA' level, 2.8 percentage points at the 'BBB' level, and almost 3.0 percentage points for speculative-grade rating scenarios.

Nevertheless, the cash flow could be negatively affected by this change. In general, when a CLO has 2.5% of excess 'CCC' category rated assets (the amount above the 'CCC' threshold, which is typically 7.5%), this equates to a reduction in the overcollateralization cushion of 0.75%, when using 70% as market value for the 'CCC' excess assets [2.5 x (1-70%)]. If the market value for the 'CCC' excess assets is lower, e.g., 40%, then the erosion in the overcollateralization cushion would be greater, at about 1.5%. Otherwise said, the coverage tests will start breaching earlier and then the senior notes start receiving their principal back earlier.

An increase in corporate default rates could have a similar, albeit more pronounced effect, as even junior 'B-' rated CLO tranches tend to have 6.5%-7.5% credit enhancement and are deferrable in nature. If we consider a 'AAA' rated tranche, with 38.5% credit enhancement, and a 'BBB' rated tranche, with 15% credit enhancement, the increase of defaulted assets to 5% (with a 38% recovery rate for 'AAA' rated notes and 55% for 'BBB') is unlikely to cause a downgrade to the senior note and it may lead to a one notch downgrade for the mezzanine tranche, based on our credit and cash flow model. Similarly, even an increase to 10% of defaulted assets would lead to a likely downgrade of the senior tranches of just one notch, while the mezzanine notes would likely face up to a two-notch downgrade. At the same time, the speculative-grade notes could suffer a greater downgrade.

These are simplified examples, mainly to provide a sense of the risk of downgrade in specific individual scenarios. In our experience, portfolio credit deterioration is not the only factor to consider. Other factors such as decisions to work out the defaulted assets or a sharp deleverage of the senior notes, which would increase the cost of debt of the structure, reducing the excess spread, also play an important role.

That said, we expect that the increases in 'CCC' category rated assets and defaults in the underlying portfolio will lead to a downgrade of the tranches, mainly at the bottom of the CLO capital structure. Even senior tranches, structured with limited cushion, may also see negative rating actions. The specific effect on individual transactions will depend on the structure and portfolio, as well as the collateral manager's role. A collateral manager may be able to boost the CLO's performance by purchasing better credit cheaply, and by building additional par, which would benefit the noteholders. At the same time, a repricing-up of new loans can increase the CLO's weighted-average spread (WAS), which can be used to cure coverage breaches. At the same rating level, for a 1 percentage point increase in the portfolio's WAS, we would usually see about a 3 percentage point increase in the breakeven default rate. Although this somewhat oversimplifies the effect of a relative change in both of these metrics, which will vary slightly among transactions, it presents an approximate indication of what the effect may be. However, this will ultimately depend on the details of each CLO's capital structure.

Appendix

Appendix I

Related Research

• European ABS And RMBS: Assessing The Credit Effects Of COVID-19, March 30, 2020
• Coronavirus Impact: Key Takeaways From Our Articles, March 27, 2020
• COVID-19: The Steepening Cost To The Eurozone And U.K. Economies, March 26, 2020
• European Corporate Securitizations: Assessing The Credit Effects Of COVID-19, March 26, 2020
• Global Covered Bonds: Assessing The Credit Effects Of COVID-19, March 25, 2020
• European CMBS: Assessing The Credit Effects Of COVID-19, March 24, 2020
• European CLO Performance Index Report Q4 2019, March 24, 2020
• COVID-19 Macroeconomic Update: The Global Recession Is Here And Now, March 17, 2020
• COVID-19 Credit Update: The Sudden Economic Stop Will Bring Intense Credit Pressure, March 17, 2020
• Coronavirus' Global Spread Poses More Serious Challenges For Airlines, March 12, 2020
• COVID-19 Will Cause A Significant Decline In Global RevPAR, Cash Flow, For Rated Lodging Companies, March 11, 2020
• Unrestrained Supply Swamps Oil Outlook: S&P Global Ratings Revises Oil & Gas Assumptions, March 9, 2020
• Global Credit Conditions: COVID-19's Darkening Shadow, March 3, 2020
• Global Auto Sales Will Downshift Again In 2020, Feb. 27, 2020
• How Much Will Coronavirus Disrupt Europe's Travel, Lodging, And Gaming Sectors?, Feb. 13, 2020
• European Corporate Credit Outlook 2020: In The Balance, Jan. 24, 2020
• The European Speculative-Grade Corporate Default Rate Is Expected To Reach 2.3% By September 2020, Dec. 6, 2019
• What's Driving Recent Rating Pressure On Certain European CLO 2.0s? March 22, 2018