2020 has been an extraordinary year for collateralized loan obligations (CLOs), and certainly one to remember. The leveraged loan market, which fuels the CLO market, was hit hard by the pandemic. Defaults and 'CCC' holdings in CLO portfolios are up, loan supply is down, and while CLO managers have been navigating the new environment by trading out of weaker corporate sectors, this strategy has in some instances come at the price of par losses. All combined, these factors have negatively affected European CLO ratings, largely in the form of CreditWatch negative placements and downgrades of junior tranches.

In this publication, we dig deeper into our rating actions on European CLOs this year, focusing on the impact of corporate rating actions on the underlying portfolios, as well as how CLO transactions' structural mitigants have limited the rating pressure on speculative-grade tranches.

Setting The Scene: European CLO Rating Actions To Date

Since March 2020, we have placed 39 European CLO ratings on CreditWatch negative, with around 65% of those actions subsequently being resolved with a downgrade, averaging one rating notch. As of the date of this publication, there are no European CLO ratings on CreditWatch negative.

Table 1

A Recap Of Corporate Credit And CLO Developments

We consider that the wave of COVID-19-related rating actions on nonfinancial corporates started around April (see "How The European CLO Market Has Developed Over 180 Days Of COVID-19," published Sept. 2, 2020). By the following month, the 12-month trailing European speculative-grade default rate had already risen to 2.7% from 2.3% a month earlier. In parallel with rising defaults, 'CCC' buckets in European CLO portfolios started to breach their limits in an increasing number of transactions. These limits are typically set at 7.5% and are designed to calculate lower par value test ratios by carrying 'CCC' balances exceeding the limit at market value.

Chart 1

At this point, European CLO ratings began facing downward pressure as a result of corporate downgrades, and CLO rating cushions--the difference between the tranche break-even default rate (BDR) and its respective scenario default rate (SDR)--began to erode. This resulted in our first and largest set of CreditWatch negative placements on European CLO ratings to date (see "Ratings On 18 Classes From 14 European CLOs Placed On Watch Negative," published April 27, 2020).

Corporate rating actions affecting CLO portfolios peaked during May and June. The average S&P Global Ratings weighted-average rating factor (SPWARF) across European CLOs passed the 2900 mark (compared with an average of 2700 in March), with average 'CCC' exposure increasing to just below 10%.

Since peaking in the second quarter, the rate of negative corporate rating actions has abated, and so has pressure on CLOs and subsequently CLO rating actions (see "Ratings On Seven Classes From Six European CLOs Placed On Watch Negative," published June 9, 2020, and "Ratings On Nine Classes From Seven European CLOs Placed On Watch Negative," published July 24, 2020).

Negative CLO Rating Actions Have Largely Affected 'BB' And 'B' Categories

Our approach to analyzing new and existing CLOs is consistent with our CLO rating framework (see "Global Methodology And Assumptions For CLOs And Corporate CDOs," published June 21, 2019). Our ratings framework considers--among other factors--multivariate stress runs and assumptions on the underlying collateral pool, at each rating level.

CLOs typically issue different tranches of liabilities and use the net proceeds to purchase a pool of assets. The cash flows generated by the assets are then used to pay back investors generally sequentially from the senior investors that hold the highest-rated (typically 'AAA') securities, to the lowest rated (for example, 'B-' rated). Any residual payments are made to equity investors, who bear the first-loss risk and hold unrated securities. Lower-rated classes of notes are typically associated with more credit risk than the higher-rated classes. Therefore, investors in these classes are compensated with a higher rate of return.

Normally, any credit-negative impact on the assets in a CLO's underlying portfolio would have some knock-on effect on the rated liabilities issued by the CLO. However, the extent of the impact differs across the rated securities, and typically the biggest impact may be on lower rated securities. This is partly because they rank lower in a CLO's priority of payments, they have lower credit enhancement levels, and they are relatively more dependent on the performance of other supporting factors, such as excess spread. Credit enhancement levels for European CLO tranches rated 'BB' and 'B' are generally in the range of 9%-11% and 6.5%-8.5%, respectively.

European CLO ratings performance this year has mostly matched the intention of their structures, in our view. The credit events over the year have almost exclusively affected speculative-grade CLO ratings so far, largely in the 'BB' and 'B' rating categories.

In addition to facing more pressure from deteriorating credit quality and their lower levels of credit enhancement, 'BB' and 'B' rated tranches depend more on the performance of other types of credit support, such as excess spread generation over the underlying portfolio's weighted-average life, all else equal, and depending on their cost of funding. In our view, excess spread plays an important role in CLOs because it provides another form of credit support at times when the CLO may be in distress. In particular, when any CLO coverage tests are breached, interest proceeds outstanding are redirected to help cure the breach by repaying noteholders sequentially. This essentially implies that all CLO noteholders have at their disposal a second resource to help repay their original principal investment in addition to principal proceeds. In other words, they have excess interest proceeds in times of potential distress.

Even so, we acknowledge that a breach of coverage tests has other knock-on effects on CLO performance. Depending on where the CLO is in its payment waterfall when the coverage test breaches, a redirection of interest proceeds to help cure a coverage test breach may conversely result in a deferral of interest due on deferrable classes of notes, which as a result may pay-in-kind (PIK). Although there are nuances in the multivariate paths of the cash flows, junior ratings that PIK--especially those which pay higher coupons--are likely to be more dependent on excess spread.

When excess spread or the weighted-average life of the underlying pool declines, this may lower the tranche's BDR at lower rating levels more than at higher rating levels, and thereby negatively affect its rating cushion (we note that a reduction in the weighted-average life may at the same time improve the SDRs, which may offset some of the reduction in rating cushion). Overall, these factors combined have pressured 'BB' and 'B' rated classes and explain why our rating actions have largely been limited to speculative-grade ratings. (For CLO tranches rated 'B-', we consider additional factors in accordance with our "Criteria For Assigning 'CCC+', 'CCC', 'CCC-', And 'CC' Ratings," published Oct. 1, 2012.)

Chart 3

European CLO Rating Actions So Far Have Been Relatively Limited

Several other reasons, in our view, explain why rating action on European CLOs have been relatively limited. Limited CLO exposure to affected corporate names, structural mitigants, and portfolio managers' strategies may be considered contributing factors.

Not all corporate rating actions have affected CLOs

Let's start with corporate rating actions. Although the downgrades that affected corporate issuers of leveraged loans were significant, this does not mean that every negative corporate rating action caused CLO credit quality to deteriorate.

Our analysis shows that just over half of the corporate rating actions from March 1 to Sept. 1 have filtered through to CLOs (330 out of 638 over the period based on the types of actions shown in chart 4). As the results show, European CLOs are not invested in every corporate on which we have lowered our rating. Based on our analysis, just over 53% of downgrades in the speculative-grade corporate universe affected European CLOs.

Chart 4

Higher credit enhancement provides more protection against headwinds

In contrast to lower-rated notes ('BB' and 'B'), higher-rated notes benefit from more credit enhancement. This means that they are also relatively less sensitive to deterioration in other performance metrics, such as a decline in excess spread over the weighted-average life of the portfolio. Overall, they are able to withstand greater levels of credit deterioration, all else being equal.

Chart 5

CLO managers have adjusted portfolios to protect credit quality

As we have discussed in recent publications and webcasts, since the start of the downturn, CLO managers have been proactively trading out of potentially weaker corporate credits and sectors (or those considered more sensitive to social distancing, such as the travel industry). They have redeployed proceeds into relatively more defensive sectors, such as health care, chemicals, and education, thereby improving the overall credit quality of their CLO portfolios. Although in some instances the trading of underlying assets has resulted in some par losses, it has limited further increases in 'CCC' rated exposures and stymied the deterioration in credit quality (see "European CLOs: The True Impact Of 'CCC' Assets On Overcollateralization Ratios," published July 9, 2020). In our view, one of the most important considerations for CLO managers was to ensure that par value and interest diversion tests remained compliant as CLOs headed toward determining the priority of payments on their payment dates. To date, very few of the European CLOs we rate have failed these tests, and no CLO so far has deferred payments on any of their deferrable classes.

Overall, we believe European CLOs have demonstrated resilience since the start of the pandemic. We acknowledge that the pandemic is not over--even with advancements in potentially available vaccines -- and therefore the impact of rating actions on CLOs will continue to evolve.

S&P Global Ratings believes there remains a high degree of uncertainty about the evolution of the coronavirus pandemic. Reports that at least one experimental vaccine is highly effective and might gain initial approval by the end of the year are promising, but this is merely the first step toward a return to social and economic normality; equally critical is the widespread availability of effective immunization, which could come by the middle of next year. We use 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.

Related Criteria

• Global Methodology And Assumptions For CLOs And Corporate CDOs, June 21, 2019
• Criteria For Assigning 'CCC+', 'CCC', 'CCC-', And 'CC' Ratings, Oct. 1, 2012

Related Research

• How The European CLO Market Has Developed Over 180 Days Of COVID-19, Sept. 2, 2020
• Ratings On Nine Classes From Seven European CLOs Placed On Watch Negative, July 24, 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
• Ratings On 18 Classes From 14 European CLOs Placed On Watch Negative, April 27, 2020