The last two months have altered the market for European collateralized loan obligations (CLOs) in a sudden and marked way. While several concerns had already been raised due to heightened risks within the European leveraged loan market, the COVID-19 pandemic has become the catalyst for abrupt changes.

Following the swift rise in negative rating actions on nonfinancial corporates over the last 60 days, data for the European CLO sector show emerging trends, as the market pivots from having its best year in terms of new transactions toward a focus on monitoring the performance of loans underlying existing transactions. The next generation of CLOs may also be very different, especially in the short term (see "Redesigning The CLO Blueprint After COVID-19," published April 21, 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 about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID-19 have pushed the global economy into recession (see our macroeconomic and credit updates here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

The Calm Before The Storm

Table 1

Chart 1

Although the novel coronavirus was already in the news at the end of February, the economic situation in the leveraged loan sector was still viewed positively.

European CLOs issued before 2013, or CLOs 1.0, had almost fully terminated, with a 1.3% default rate in 20 years. At the same time, CLOs 2.0, those issued from 2013 onward, displayed very stable performance, with only one tranche downgraded among European transactions in their history.

The 12-month trailing speculative-grade default rate for corporates in Europe, at 2.4% as of March 2020, continued to be minimal and lower than the historical average.

The Clouds Begin To Burst

On March 11, the World Health Organization declared COVID-19 a pandemic. We revised downward our global macroeconomic outlook shortly after (see "COVID-19 Macroeconomic Update: The Global Recession Is Here And Now," published on March 17, 2020).

In February, we took 21 negative rating actions globally on corporates and sovereigns that we deemed to be related to COVID-19 (negative rating actions include outlook revision to negative, CreditWatch negative placement, or downgrade). Concurrently, there was the collapse in global oil prices, which caused the overall number of speculative-grade companies to more than triple so far in 2020, increasing to 442 from 128 in December 2019 (see "COVID-19: Coronavirus- And Oil Price-Related Public Rating Actions On Corporations, Sovereigns, And Project Finance To Date").

As of April 30, 2020, that figure was 1,774. The wave of negative rating actions has affected several sectors, geographies, and products.

From March to April, the rating breakdown for corporate loans contained in European CLO portfolios evolved in this way:

Chart 2

Charts 3 and 4 show how the rating transitions for corporates in European CLO portfolios have affected the portfolio exposures. According to our CLO criteria, a corporate rating on CreditWatch negative would be notched down by one rating in our CLO analysis. For example, we would treat a corporate rating of 'B/WatchNeg' as a 'B-' rating in our CLO analysis (see "Global Methodology And Assumptions For CLOs And Corporate CDOs," published June 21, 2019).

Chart 3

Chart 4

These are average figures and display a large dispersion. They are also based on the latest trustee report available, which may have reflected the portfolios as of January. Actions that each portfolio manager took to counterbalance the recent wave of negative rating actions will only be evident in the next couple of months.

Chart 5 shows the rating category evolution in European CLOs. Each box plot represents the distribution by percentage of notional amount in European CLOs exposed to the 'B', 'CCC', and 'D' rating categories for each day.

Chart 5

At the same time, not all CLOs are created equal, and some structural features--such as higher credit enhancement, higher overcollateralization triggers, or even better economic arbitrage--may allow some to perform better.

Not All Waves Are The Same

During the tempest, it is challenging to see the boats that are staying afloat. Instead, it's easier to consider the broad impact on all of them. The same concept may apply when looking at the early effects on CLOs.

As CLO 1.0 credit performance was solid even during the last recession, and considering that the current CLO structure benefits from greater credit enhancement per rating level, shorter reinvestment periods, pools backed by corporate debt only, and regulations requiring "skin in the game," it is possible to assume that stable performance will continue for post-2012 CLOs.

However, there are unique challenges, including those that emerged before COVID-19, such as high leverage ratios, EBITDA add-backs, and covenant-light (cov-lite) loans. Even considering these, our recovery expectation is still slightly lower than 60%, which is much lower than the historical average of 73%, but typically much higher than what transaction documents are pledging for 'AAA' rated CLO tranches.

Generally, recovery ratings for CLOs have remained largely unchanged.

Chart 6

When we look at the breakdown by industry and geography, we can see how corporate rating actions have been affecting the Europe, Middle East, and Africa region. The charts below show the number of corporate downgrades and/or negative CreditWatch placements, and of those, how many are in CLOs.

Chart 7

Chart 8

Chart 9

At the same time, we note that European CLOs are also affected by corporate rating actions in the U.S. However, given the lower exposure, only 49 of over 900 corporate rating actions in the U.S. affected European CLOs.

Nevertheless, to grasp the full picture, we look at the same breakdown for our subset of CLOs. The charts below show the facility notional amounts affected in CLOs by corporate rating actions and the average notch change we would apply in CLOs.

Chart 10

Chart 11

The effect has left all CLO facilities exposed at different levels. The split by CLOs and their facility exposure by total facility amount ranges from 20%-40% of par amount (see table 2).

Table 2

Is This The Perfect Storm For CLOs?

It is difficult to say. The speed and number of rating actions on corporate issuers will continue to affect the situation.

From these last 60 days, we believe CLOs are showing strength when comparing the negative corporate rating actions that have affected them to the total number.

Of the European CLOs we rate, 17% by balance has been affected, with only €8 billion subject to negative rating actions. In some instances, multi-notch downgrades occurred, though the amount is not prominent.

Our data show the level of 'CCC' assets has increased, but at the same time, while the ratings on 87 corporate obligors are now considered nonperforming ('CC', 'C', selective default ['SD'], or 'D'), the average level of nonperforming ratings on obligors in European CLO portfolios is nine, or 0.13%, up from 0.07% in early March. The total amount by balance is just below €59 million, across 29 CLOs.

Negative rating actions are continuing, and it is difficult for us to believe that we are close to the end of the turbulence. However, we believe looking at the data as they materialize provides an anchor.

Related Research

• April Accounts For Half Of Defaults So Far In 2020, April 30, 2020
• COVID-19: Coronavirus- And Oil Price-Related Public Rating Actions On Corporations, Sovereigns, And Project Finance To Date, April 28, 2020
• COVID-19: Coronavirus-Related Public Rating Actions On Nonfinancial Corporations And Affected European CLOs, April 30, 2020
• Redesigning The CLO Blueprint After COVID-19, April 21, 2020
• 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 CLOs: 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
• Closing The Low European CLO 1.0 Default Chapter, Onto The Next, Sept. 4, 2019
• A Cycle Turn Will Test European CLO 2.0 Defaults, June 7, 2019
• What's Driving Recent Rating Pressure On Certain European CLO 2.0s? March 22, 2018