S&P Global Ratings' July 9, 2020 webcast "What's Next For European CLOs?," addressed key themes, challenges, and opportunities in the coming months for European collateralized loan obligations (CLOs). Specifically, we discussed CLO trading activity, the impact of COVID-19 on overcollateralization ratios, what could cause interest to start deferring, and key trends in European CLO portfolio overlap (topics covered in our recent publications, see "Related Research").

In the first half of the year, downgrades among speculative-grade companies rose markedly. Following this increase in negative rating actions on nonfinancial corporates in March and April, we looked at their impact on CLO portfolio exposures over 60 days and 180 days.

In this quarterly index publication, we 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.

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 continued to stabilize following the slowdown in corporate rating downgrades and flattening of the 'CCC' curve.

Table 1

Nevertheless, speculative-grade corporate ratings are exposed to downside risk, particularly those within sectors that are most vulnerable to social distancing such as retail, consumer products, transportation, and leisure. We expect the European trailing 12-month speculative-grade corporate default rate to rise to 8.5% by June 2021 from 3.4% at the end of June 2020 (which has increased by nearly 50% from 2.3% over the last 12 months).

S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The current consensus among health experts is that COVID-19 will remain a threat until a vaccine or effective treatment becomes widely available, which could be around mid-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.

Eighteen CLO Tranches Downgraded By An Average Of One Notch

To date, we have placed 39 ratings from 29 European CLOs on CreditWatch negative (see "Related Research"), comprising 3% of our rated European CLO universe. In third-quarter 2020, we resolved the CreditWatch placements on 25 ratings, of which 18 (72%) were downgraded and 7 (28%) affirmed (see table 2 below and "Related Research").

Table 2

The downgrades have largely been in the 'BB' space with an average of a one notch change. These reflected a combination of factors, primarily a decline in portfolio credit quality following downgrades, an increased exposure to 'CCC' category loans, as well as par loss from trading losses and defaults leading to lower credit enhancement. Although credit deterioration, which may be indicated by an increasing S&P Global Ratings' weighted-average rating factor (SPWARF), has been a key rating factor, the impact on CLO transactions has varied, depending on the initial structure and manager's subsequent strategy in managing the portfolios. For instance, some transactions were structured with higher levels of starting cushions. In others, a higher weighted-average spread or shorter weighted-average life compensated for the portfolio credit deterioration or increased risk of a higher WARF.

We expect to resolve the remaining 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.

Updates On European CLO Documentation: Managers Seek Greater Distressed Asset Flexibility

After a sharp slowdown in March to May, European CLO issuance picked up from June bringing year-to-date issuance volume to €15.5 billion from 46 deals compared with €23.4 billion from 56 deals in the same period last year. Most of the new issue activity resulted from the terming out of existing warehouses with pre-COVID loans where the focus was to launch deals, even if the economics were not ideal. Nevertheless, investor appetite seems to be returning and arbitrage conditions improving with 'AAA' liability spreads significantly tightening away from the 200 basis points (bps) seen earlier in the year with the last couple of transactions pricing at 110 bps.

Within that, CLO documentation continues to evolve. Given the focus on overcollateralization tests, we are seeing proposed variations in certain definitions that would affect overcollateralization haircuts--for example, what would constitute a 'CCC' asset or a discount obligation. As negative rates look set to stay, we have also seen proposed changes to interest smoothing amount definitions to allow managers to reduce the amount of interest required to be trapped in the interest smoothing account.

The most significant change recently introduced to European CLO documentation is the increased distressed asset flexibility managers are seeking in anticipation of increased defaults in the next downturn. Standard CLO documentation has historically limited the ability of CLOs to participate in loan restructurings involving injection of new money, which has allowed non-CLO distressed debt investors to take advantage of such restrictions to extract value from CLOs through certain restructuring practices (see "Acosta Inc.'s Modern Day Bankruptcy: A CLO-Distressed Funds Clash," published May 7, 2020). The introduction of loss mitigation loans hence aims to lessen this risk and help CLOs maximize recoveries on their distressed credits.

Under the transaction documents of recent European CLO transactions with this feature, loss mitigation loans are typically defined as assets of an existing collateral obligation held by the issuer offered in connection with the bankruptcy, workout, or restructuring of such obligation, purchased to improve the recovery value of such related collateral obligation.

The purchase of loss mitigation loans is generally not subject to the reinvestment criteria or the eligibility criteria although it may be subject to some criteria such as senior or pari passu to the existing obligation. Often, the purchase receives no credit either in the principal balance definition or par coverage tests, although where the loss mitigation loan meets the eligibility criteria with certain exclusions, it is sometimes accorded defaulted treatment.

While the overall objective of loss mitigation loans is positive, it can also lead to par erosion, as additional funds will be placed with an entity that is under distress or in default. In addition, rather than the use of funds to deleverage, the purchases of such loans would also increase the level of nonperforming assets in the portfolio, which could increase the credit risk in the transaction despite the prospect of higher recoveries. Hence, this may cause greater volatility in our ratings if the positive effect of such loans do not materialize. The presence of a bucket, restrictions on the use of principal proceeds to purchase such assets, and limitations in reclassifying proceeds received from such assets from principal to interest in the transaction documents, help to mitigate the risk, in our view.

CLOs may purchase loss mitigation loans using either interest proceeds, principal proceeds, or amounts standing to the credit of the supplemental reserve account. To date, we have generally seen in recent European CLO transactions the usage of principal proceeds subject to (1) passing par coverage tests and the manager having built sufficient excess par in the transaction so that (2) the principal collateral amount is equal to or exceeding the portfolio's target par balance after the reinvestment.

In the transactions we have reviewed, interest proceeds may also be used to purchase loss mitigation loans. As these purchases are made directly from the interest account without going through the interest priority of payments, such payments are effectively senior in the waterfall. This may lead to insufficient interest to pay noteholders on the following interest payment date and also less interest to cure the coverage test hence affording less protection to senior noteholders. To mitigate this risk, transaction documents reviewed to date typically include the use of interest proceeds subject to (1) all coverage tests passing following the purchase, and (2) the manager determining there are sufficient interest proceeds to pay interest on all the rated notes on the upcoming payment date.

To protect the transaction from par erosion, we note that the transaction documents typically provide that any distributions received from loss mitigation loans which are either (1) purchased with the use of principal, or (2) purchased with interest or amounts in the supplemental account, but which have been afforded credit in the coverage test, to irrevocably form part of the issuer's principal account proceeds and cannot be recharacterized as interest.

As the ability to purchase loss mitigation loans is a fairly new concept in European CLOs, we expect more proposed variations in CLO documentation and for the language to continue to evolve. Therefore, it is important for investors and market participants to review the definitions and flow of funds in detail. Some particular factors to consider are what proceeds may be used to purchase such obligations and the limitations to such purchases. Another factor is the treatment of such assets in key CLO tests and which account the loss mitigation loan proceeds go to (principal, interest, or supplemental reserve account), as this also ultimately determines the risk-benefit balance of loss mitigation loans between debt and equity noteholders.

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 Further In Second-Quarter 2020

Overall, CLO performance in second-quarter 2020 deteriorated further since the previous three quarters, with an increase in defaulted and 'CCC' category rated assets, and worsening of the S&P Global Ratings' weighted-average rating factor (SPWARF), credit enhancement and overcollateralization cushions. 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 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 June 2020, was:

• 2013 vintage CLOs: 6.68% of total assets (up from 2.31% in March 2020);
• 2014 vintage CLOs: 7.14% of total assets (up from 4.14% in March 2020);
• 2015 vintage CLOs: 5.51% of total assets (up from 3.39% in March 2020);
• 2016 vintage CLOs: 6.43% of total assets (up from 2.96% in March 2020);
• 2017 vintage CLOs: 6.74% of total assets (up from 3.03% in March 2020);
• 2018 vintage CLOs: 6.39% of total assets (up from 2.62% in March 2020); and
• 2019 vintage CLOs: 4.13% of total assets (up from 1.56% in March 2020).

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 has increased but 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 March 2020 to June 2020, the percentage of defaulted assets (i.e., assets from obligors rated 'CC', 'C', 'SD' [selective default], or 'D') slightly increased for the all vintages.

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

• 2013 vintage CLOs: 0.30% of total assets (up from 0.29% in March 2020);
• 2014 vintage CLOs: 0.60% of total assets (up from 0.02% in March 2020);
• 2015 vintage CLOs: 0.61% of total assets (up from 0.16% in March 2020);
• 2016 vintage CLOs: 0.16% of total assets (up from 0.00% in March 2020);
• 2017 vintage CLOs: 0.31% of total assets (up from 0.05% in March 2020);
• 2018 vintage CLOs: 0.28% of total assets (up from 0.06% in March 2020); and
• 2019 vintage CLOs: 0.08% of total assets (up from 0.04% in March 2020).

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 second-quarter 2020, the overall SPWARF increased to 2,917 from 2,915.

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 4.96, the WAL is decreasing quarter on quarter.

Chart 11

Scenario default rates (SDRs) slightly 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 slightly improved since first-quarter 2020, decreasing to 64.36% from 64.56%.

Chart 12

Cash Flow Metrics

Credit enhancement has slightly worsened

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 across the capital structure has slightly worsened due to a combination of trading losses and an increase in defaulted assets since first-quarter 2020.

Table 3

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 have worsened

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 have reduced for all the cohorts due to an increase in defaulted and "CCC" category assets (see chart 14).

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

• 2013 vintage CLOs: 5.68% (down from 10.78% in March 2020);
• 2014 vintage CLOs: 4.40% (down from 12.73% in March 2020);
• 2015 vintage CLOs: 7.05% (down from 8.65% in March 2020);
• 2016 vintage CLOs: 8.50% (down from 9.71% in March 2020);
• 2017 vintage CLOs: 7.47% (down from 9.52% in March 2020);
• 2018 vintage CLOs: 6.64% (down from 9.26% in March 2020); and
• 2019 vintage CLOs: 8.82% (down from 9.57% in March 2020).

Chart 14

Subordinated O/C ratios have worsened

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 March 2020 to June 2020, the subordinated O/C ratios has reduced for all the cohorts (see chart 15).

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

• 2013 vintage CLOs: 1.42% (down from 4.17% in March 2020);
• 2014 vintage CLOs: 0.50% (down from 3.86% in March 2020);
• 2015 vintage CLOs: 2.31% (down from 3.43% in March 2020);
• 2016 vintage CLOs: 3.57% (down from 4.47% in March 2020);
• 2017 vintage CLOs: 2.81% (down from 4.05% in March 2020);
• 2018 vintage CLOs: 2.10% (down from 4.08% in March 2020); and
• 2019 vintage CLOs: 3.77% (down from 4.47% in March 2020).

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.

Appendix

Appendix 1

Appendix 2

Related Criteria

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

Related Research

• Credit Conditions Europe: Ill-Prepared For Winter, Sept. 29, 2020
• Barings Euro CLO 2020-1 DAC European Cash Flow Notes Assigned Preliminary Ratings, Sept. 29, 2020
• CVC Cordatus Loan Fund XVIII DAC European Cash Flow CLO Notes Assigned Preliminary Ratings, Sept. 29, 2020
• Deer Park CLO DAC European Cash Flow Notes Assigned Ratings, Sept. 17, 2020
• Ratings On Five Classes From Two European CLOs Placed On CreditWatch Negative, Sept. 15, 2020
• 2019 Annual Global Leveraged Loan CLO Default And Rating Transition Study, Sept. 2, 2020
• How the European CLO Market Has Developed Over 180 Days Of COVID-19, Sept. 2, 2020
• CLO Portfolio Overlap: European Managers May Look Beyond Their First Choice Of Assets In The COVID-19 Era, Sept. 1, 2020
• RRE 4 Loan Management European Cash Flow CLO Notes Assigned Ratings, Aug. 27, 2020
• Ratings Recap Of August 2020 European CLO CreditWatch Resolutions, Aug. 18, 2020
• Credit And Economic Deterioration Signals A Rising European Speculative-Grade Default Rate Despite Market Optimism, Aug. 18, 2020
• Ratings On Nine Classes From Seven European CLOs Placed On Watch Negative, July 24, 2020
• Ratings Recap Of July 2020 European CLO CreditWatch Resolutions, July 14, 2020
• European CLOs: The True Impact Of ‘CCC’ Assets On Overcollateralization Ratios, July 9, 2020
• Ratings On Seven Classes From Six European CLOs Placed On Watch Negative, June 9, 2020
• Acosta Inc.’s Modern Day Bankruptcy: A CLO-Distressed Funds Clash, May 7, 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
• Redesigning The CLO Blueprint After COVID-19, April 21, 2020
• Europe Braces For A Deeper Recession In 2020, April 20, 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
• Glossary Of Cash Flow CLO Performance Index Fields, Jan. 30, 2009