COVID-19 concerns persist as much of the market's focus remains on how the pandemic will pan out and it may affect European collateralized loan obligations (CLOs) (see "European CLOs: Assessing The Credit Effects Of COVID-19," published on March 25, 2020)

In the first quarter of the year, downgrades among speculative-grade companies rose markedly, particularly in March. Following this increase in negative rating actions on nonfinancial corporates in March and April, we looked at their impact on CLO portfolio exposures (see "How COVID-19 Changed The European CLO Market In 60 Days," published on May 6, 2020).

In this quarterly index publication, we incorporated the 2019 vintage and 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. We note that our Q1 2020 quarterly report covers the period between the end of November 2019 and February, hence we would have not reflected the impact of COVID-19 in the portfolio composition.

In table 1 below, we show some selected credit metrics for 111 S&P Global Ratings-rated European CLOs that will be reinvesting for all of 2020 since the beginning of the year. We observe that since May, the average credit quality of reinvesting CLO portfolios has appeared to stabilize.

Table 1

Nevertheless, we expect broad-based credit deterioration to continue for many speculative-grade companies in certain sectors such as leisure, consumer services, transportation, energy, and natural resources as they find their solvency stretched amid falling revenue. We expect the European trailing 12-month speculative-grade corporate default rate to rise to 8.5% by March 2021 from 2.4% in March 2020 (see "The European Speculative-Grade Corporate Default Rate Could Reach 8.5% by March 2021," published on June 8, 2020).

To date, we have placed 25 classes from 20 European CLOs on CreditWatch negative (see "Ratings On 18 Classes From 14 European CLOs Placed On Watch Negative," published on April 27, 2020, and "Ratings On Seven Classes From Six European CLOs Placed On Watch Negative," published on June 9, 2020). Our rating actions reflected a combination of multiple factors that affected these transactions, with the primary one being the increased exposure to 'CCC' category loans. Other factors included pressure on the overcollateralization ratios, a decline in portfolio credit quality, credit enhancement, and indicative preliminary cash flow results. We also considered qualitative factors to reflect our forward-looking view of the CLO portfolios. We expect to resolve the CreditWatch placements within 90 days of the rating action after we complete a cash flow analysis and committee review for each of the affected transactions.

European CLO Structures Continue to Evolve

On the new issue front, in April, we published an article on how structural features on European CLOs could evolve in the COVID world (see "Redesigning The CLO Blueprint After COVID-19," published on April 21, 2020) Since then, we have seen 16 new issuances price with some of these features, such as lower leverage, removal of the 'B' rated (and for some, the 'BB') tranche, and shorter reinvestment periods--as well as the introduction of some additional features such as the inclusion of a delayed-draw tranche and the reintroduction of the turbo overcollateralization (O/C) test.

We note the difference between this turbo O/C test and the other type of turbo redemption feature (also known as "variable amortizing notes") we have seen in recent transactions. In the latter, interest proceeds used to redeem the most junior notes are made only after the cure of the most junior O/C test (in accordance with the note payment sequence starting from the most senior noteholders) and reinvestment O/C test. (For more information on the latter type of turbo feature i.e., variable amortizing notes, please see https://www.spglobal.com/ratings/en/research-insights/videos/2019-12-11-clo-simplified-turbo-redemption

The turbo O/C test works differently: when the most junior O/C test is breached, up to a certain percentage (e.g., 50%) of available interest proceeds after paying the most junior notes' deferred interest is used to cure the test by paying down the most junior notes rather than the senior notes. This may provide less protection to senior noteholders than a transaction with a standard junior O/C test, which uses all available interest proceeds to pay down the notes sequentially.

To understand the sensitivity of its rating on a typical European CLO to potential negative stresses, S&P Global Ratings explored 10 different scenario analyses and the impact of various stresses (see "How Credit Distress Due To COVID-19 Could Affect European CLO Ratings," published on April 2, 2020). To provide greater market transparency, we have subsequently incorporated five of these scenario analyses in our new issue media releases to facilitate the comparison of transactions.

Although our rating framework has not changed, in light of the rapidly shifting credit dynamics within CLO portfolios due to rating actions (downgrades, CreditWatch placements, and outlook changes) on speculative-grade corporate loan issuers, we introduced an overlay of additional qualitative factors in our rating analysis by considering a minimum cushion between the break-even default rate (BDR) and the scenario default rate (SDR) of 1% for new issue transactions.

The level of the minimum cushion depends on several factors such as the percentage of assets rated 'B-', rated 'CCC', and the percentage of assets with ratings on CreditWatch negative or on negative outlook, amongst others. (See "S&P Global Ratings May Add Additional Qualitative Factors When Rating CLO Tranches Due To Changing Credit Dynamics," published on April 9, 2020" for more details.) For the new issue transactions that we have rated to date, the minimum cushion requirement for reinvestment CLOs has ranged between 1.0% to 1.5%, while actual cushions in transactions have generally exceeded these ranges.

S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The consensus among health experts is that the pandemic may now be at, or near, its peak in some regions but will remain a threat until a vaccine or effective treatment is widely available, which may not occur until the second half of 2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

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 Collateral Performance Deteriorates Slightly In First-Quarter 2020

Overall, CLO performance in first-quarter 2020 deteriorated slightly since the previous three quarters, with an increase in 'CCC' category rated assets, and worsening of the S&P Global Ratings' weighted-average rating factor (SPWARF) and SDR. Most of the other metrics we capture 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 1 to 7). Note that we have considered transactions that have been 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.

Chart 1

Chart 2

Chart 3

Chart 4

Chart 5

Chart 6

Chart 7

Exposure to 'CCC' rated assets has increased

'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 slightly worse 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 February 2020, was:

• 2013 vintage CLOs: 2.29% of total assets (up from 1.80% in November 2019);
• 2014 vintage CLOs: 2.62% of total assets (down from 2.95% in November 2019);
• 2015 vintage CLOs: 3.14% of total assets (down from 3.35% in November 2019);
• 2016 vintage CLOs: 2.03% of total assets (up from 1.88% in November 2019);
• 2017 vintage CLOs: 1.94% of total assets (unchanged from 1.94% in November 2019);
• 2018 vintage CLOs: 2.19% of total assets (up from 1.91% in November 2019); and
• 2019 vintage CLOs: 1.40% of total assets (down from 1.61% in November 2019).

Chart 8

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.

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 November 2019 to February 2020, the percentage of defaulted assets (i.e., assets from obligors rated 'CC', 'C', 'SD' [selective default], or 'D') slightly increased for the 2018, and 2019 vintages, and decreased for the 2013, 2015, and 2017 cohort. It remains unchanged for the 2014 and 2016 cohort.

As of February 2020, the percentage of defaulted assets in each underlying collateral portfolio was:

• 2013 vintage CLOs: 0.42% of total assets (down from 0.52% in November 2019);
• 2014 vintage CLOs: 0.00% of total assets (unchanged from 0.00% in November 2019);
• 2015 vintage CLOs: 0.14% of total assets (down from 0.18% in November 2019);
• 2016 vintage CLOs: 0.02% of total assets (unchanged from 0.02% in November 2019);
• 2017 vintage CLOs: 0.05% of total assets (down from 0.15% in November 2019);
• 2018 vintage CLOs: 0.28% of total assets (up from 0.14% in November 2019); and
• 2019 vintage CLOs: 0.02% of total assets (up from 0.00% in November 2019).

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

Chart 9

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

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 first-quarter 2020, the overall SPWARF increased to 2,801 from 2,652.

Chart 10

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 11

Scenario default rates (SDRs) worsen

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 slightly worsened since fourth-quarter 2019, increasing to 63.84% from 61.44%.

Chart 12

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 2019-2020.

Table 2

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 13

Senior O/C ratios remained stable

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 were stable for all the cohorts except 2014, 2015 and 2018 (see chart 14).

The senior O/C ratio test cushions (based on reported information) as of February 2020 were:

• 2013 vintage CLOs: 11.26% (up from 9.12% in November 2019);
• 2014 vintage CLOs: 13.24% (down from 13.44% in November 2019);
• 2015 vintage CLOs: 9.98% (down from 10.74% in November 2019);
• 2016 vintage CLOs: 9.89% (up from 9.88% in November 2019);
• 2017 vintage CLOs: 9.83% (up from 9.71% in November 2019);
• 2018 vintage CLOs: 9.48% (down from 9.54% in November 2019); and
• 2019 vintage CLOs: 9.70% (up from 9.45% in November 2019).

Chart 14

Subordinated O/C ratios remained steady

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 November 2019 to February 2020, the subordinated O/C ratios remained steady with slightly better performance for the older 2013, 2014 vintages due to deleveraging (see chart 15).

As of February 2020, the subordinated O/C ratio test cushions (based on reported information) were:

• 2013 vintage CLOs: 4.21% (up from 3.76% in November 2019);
• 2014 vintage CLOs: 4.21% (up from 3.77% in November 2019);
• 2015 vintage CLOs: 3.67% (down from 3.88% in November 2019);
• 2016 vintage CLOs: 4.61% (up from 4.60% in November 2019);
• 2017 vintage CLOs: 4.26% (up from 4.23% in November 2019);
• 2018 vintage CLOs: 4.25% (down from 4.31% in November 2019); and
• 2019 vintage CLOs: 4.48% (up from 4.45% in November 2019).

Chart 15

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

• The European Speculative-Grade Corporate Default Rate Could Reach 8.5% By March 2021, June 8, 2020
• The U.S. Speculative-Grade Corporate Default Rate Is Likely To Reach 12.5% By March 2021, May 28, 2020
• The European Crisis Backstop Is Underpinning Corporate Funding Conditions, May 19, 2020
• How COVID-19 Changed The European CLO Market In 60 Days, May 6, 2020
• Ratings On 18 Classes From 14 European CLOs Placed On Watch Negative, April 27, 2020
• Credit Conditions In Europe Darken As Costs Of Lockdowns Add Up, April 27, 2020
• Redesigning The CLO Blueprint After COVID-19, April 21, 2020
• Europe Braces For A Deeper Recession In 2020, April 20, 2020
• First-Quarter 2020 CDO Monitor Benchmarks Reveal Relative Credit Quality And Diversity Of CLO Portfolios, April 10, 2020
• S&P Global Ratings May Add Additional Qualitative Factors When Rating CLO Tranches Due To Changing Credit Dynamics, April 9, 2020
• How Credit Distress Due To COVID-19 Could Affect European CLO Ratings, April 2, 2020
• European CLOs: Assessing The Credit Effects Of COVID-19, March 25, 2020
• CLO Spotlight: Fourth-Quarter 2019 CDO Monitor Benchmarks Reveal Relative Credit Quality And Diversity Of CLO Portfolios, Jan. 24, 2020
• 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
• Glossary Of Cash Flow CLO Performance Index Fields, Jan. 30, 2009