Key Takeaways
- The collateralized loan obligation (CLO) sector has below average exposure to environmental credit factors, given the diversification of collateral pools by obligor, industry, and geography.
- Social credit factors are below average given the diversity of the collateral pools. We believe exposure to social credit factors would be relatively higher in transactions backed by small and midsize enterprises (SMEs).
- Governance credit factors are average given that the collateral manager can change the credit quality of the collateral pool during the reinvestment period. Our assessment of each underlying obligor's creditworthiness accounts for any material governance credit factors. At the CLO issuer level, the roles and responsibilities of each transaction party and the allocation of cash flows are well defined, contributing to a strong governance framework.
Analytic Approach
Environmental, social, and governance (ESG) risks and opportunities can affect an obligor's capacity to meet its financial commitments in many ways. S&P Global Ratings incorporates these factors into its ratings methodology and analytics, which enables analysts to factor near-, medium-, and long-term effects--both qualitative and quantitative--during multiple steps in the credit analysis. Strong ESG credentials do not necessarily indicate strong creditworthiness (see "The Role Of Environmental, Social, And Governance Credit Factors In Our Ratings Analysis," published on Sept. 12, 2019).
Our credit ratings on structured finance transactions incorporate ESG credit factors when, in our opinion, they could affect the likelihood of timely payment of interest or ultimate repayment of principal by the legal final maturity date of the securities. However, in most cases, exposure to ESG credit factors in structured finance transactions is indirect or mitigated by legal and structural features already embedded in typical transactions.
Chart 1
Our ESG industry report cards qualitatively explore the relative exposures (average, below average, above average) of different sectors to ESG credit factors over the short-, medium-, and long-term. This sector comparison is not an input to our credit ratings or a component of our credit rating methodologies; it is based on our current qualitative, forward-looking opinion of potential credit risks across sectors. In addition, the structured finance ESG industry report cards list examples of ESG credit factors for the sector that may have a more positive or negative influence on a transaction's credit quality compared to sector peers or the broader sector.
The qualitative assessment of the relative exposure to ESG credit factors for each sector reflects the potential exposure to ESG risks. It does not consider the presence of structural features that could mitigate these risks (e.g. credit enhancement, short-time horizon of a transaction, insurance, etc.). Therefore, even if there is a material ESG credit factor for a given sector or transaction, there may ultimately be no ratings impact if structural mitigants are present. This is because we assign issue credit ratings to structured finance securities. These credit opinions address the likelihood of repayment of a specific financial obligation, and consider forms of credit enhancement, such as collateral security and subordination. This differs from issuer credit ratings (ICR) that we assign to corporates and sovereigns, for example. Our ICRs are opinions about an obligor's overall creditworthiness, and do not apply to any specific financial obligation, as they do not take into account the nature and provisions of the obligation, their standing in bankruptcy or liquidation, statutory preferences, or their legality and enforceability. Therefore, ESG credit factors that could affect a corporate issuer's ICR may not be material to a structured finance issue credit rating, and vice versa (see "S&P Global Ratings Definitions," published on Jan. 5, 2021).
ESG Credit Factors
We define ESG credit factors as ESG risks, or opportunities, that influence an obligor's capacity and willingness to meet its financial commitments. This influence could be reflected, for example, through reduced ability of the underlying borrowers to repay the securitized receivables, the value of any collateral, disruptions in servicing or transaction cash flows, financial exposures to transaction counterparties, or increased legal and regulatory risks.
Chart 2
This report explores how ESG credit factors could influence the credit quality of CLOs and provides a benchmark for typical ESG considerations in the sector. Specific transactions may be exposed to ESG credit factors that could have a more positive or negative influence on the credit rating than the sector benchmark. These comparative views of ESG risks across transactions are typically qualitative at present, because there are currently limited ESG data points that are widely available to quantify the relative risks. Over time, we expect that a common taxonomy for ESG credit factors across structured finance sectors will emerge, at which point more data will become available to strengthen our analysis of ESG credit factors.
In our published rating rationales, we expect to provide more insight and transparency of any ESG credit factors that are material to our credit ratings in a dedicated ESG paragraph. Our goal is to highlight how a transaction compares to our ESG sector benchmark (where applicable), identify the relative ESG risks and opportunities, and discuss any structural mitigants to these risks. However, if in our view ESG credit factors are not material to the credit risk profile of a transaction, we generally would not make any specific disclosures beyond a reference to our ESG sector benchmarks, where applicable. Through this initiative we aim to highlight how our rating analysis has accounted for specific ESG credit factors and add transparency around which ESG credit factors could drive future rating changes, if any.
CLO ESG Benchmark
Our ESG sector benchmark for CLOs consists of an actively managed pool of corporate debt (loans or bonds), diversified by obligor, industry, and geography. Our benchmark CLO has covenants and parameters that the managers adhere to during the reinvestment period, when the manager can trade loans or bonds in the pool. These include conditions for reinvesting sale or payment proceeds, passing portfolio profile and coverage tests, and maintaining portfolio credit quality. There are also rules governing trading plans and the extent to which they enable preservation of the collateral's principal or contain risk factors that may erode credit enhancement.
Exposure to environmental credit factors for the benchmark is considered below average, given the diversification by obligor, industry, and geography. Our assessment of each underlying obligor's creditworthiness accounts for any material environmental credit factors, which in turn is reflected in our asset default rate assumptions for the CLO portfolio. Portfolio concentrations by obligor, industry, or geography could increase the exposure to environmental credit factors.
Social credit factors are considered below average given the diversification in our benchmark portfolio. Social credit factors that affect our assessment of each underlying obligor's creditworthiness are reflected in our asset default rate assumptions for the CLO portfolio. In our view, exposure to social credit factors would be relatively higher for transactions backed by SMEs. For such CLOs, financing programs may be available to support the flow of credit to these borrowers, which typically have lower credit quality than corporate debt portfolios.
Exposure to governance credit factors is average. Given the nature of structured finance transactions, most have relatively strong governance frameworks through, for example, the generally very tight restrictions on what activities the special-purpose entity can undertake compared to other entities. Given that our ESG benchmark has a reinvestment period, the collateral manager has a more active role over the transaction's life, and the manager may through trading expose investors to lower-credit-quality obligors. Our assessment of each underlying obligor's creditworthiness considers governance credit factors, which in turn is reflected in our asset default rate assumptions for the CLO portfolio. In our view, CLO transactions with relatively higher exposure to governance credit factors would be those with weaker covenants and portfolio parameters.
Environmental Credit Factors
ESG Benchmark: Below Average Exposure
| Environmental Factors | ||||
|---|---|---|---|---|
| Greenhouse gas emissions | Natural conditions | Pollution | Other environmental factors | Environmental benefits |
| Concentrations by obligor, industry, or geography may increase exposure to climate transition risks. | Concentrations by obligor, industry, or geography may increase exposure to potential natural disasters or other physical climate-related risks, such as hurricanes, wildfires, earthquakes, and flooding. | Concentrations by obligor, industry, or geography may increase exposure to pollution risks. | Generally not a potential material exposure for this asset class. | Sustainability-linked loans could result in a reduction in excess spread if environmental targets are achieved. Alternatively, loans with step-up rates if targets are not met could benefit the transaction's cash flows. |
| A key transaction party's operations may be exposed to physical climate risks, potentially resulting in a disruption in payments. | Exclusion of a significant number of controversial industries as eligible assets could limit trading opportunities for the collateral manager and potentially increase industry exposure. | |||
| The rating on the sovereign where the securitized assets are domiciled can cap structured finance transaction ratings. The sovereign rating may be affected by natural disasters or other climate change-related risks. | ||||
Corporate Sector Classification For Environmental Credit Factors
Chart 3
Social Credit Factors
ESG Benchmark: Below Average Exposure
| Social Factors | |||
|---|---|---|---|
| Health and safety | Consumer related | Human capital management | Social benefits |
| Concentrations by obligor, industry, or geography may increase exposure to restrictions implemented to control a pandemic. This could result in a deterioration in credit quality of underlying obligors, particularly in industries directly exposed to social distancing restrictions such as hotels, restaurants, and, leisure, entertainment, and retail. | Concentrations by obligor, industry, or geography may increase exposure to consumer-related risks. | Concentrations by obligor, industry, or geography may increase exposure to human capital management risks. | Sustainability-linked loans could lower excess spread if social targets are achieved. Alternatively, loans with step-up rates if targets are not met could benefit the transaction's cash flows. |
| Exclusion of a significant number of controversial industries as eligible assets could limit trading opportunities for the collateral manager and potentially increase industry exposure. | |||
| Programs that help provide access to affordable finance for SMEs, such as government guarantees or incentives, may reduce asset default rates or increase recoveries. However, lower interest rates for these borrowers may also reduce excess spread in transactions. | |||
Governance Credit Factors
ESG Benchmark: Average Exposure
| Governance Factors | |||
|---|---|---|---|
| Strategy, execution, and monitoring | Risk management and internal controls | Transparency | Other governance factors |
| Collateral managers with limited experience, capacity, or systems not in line with market standards could experience higher losses or increased operational risk. | During the reinvestment period, the portfolio's credit quality, weighted-average spread, recoveries, or other parameters may change depending on various factors such as the collateral manager's ability to make trades that may lower these metrics. | Concerns on data quantity, quality, and timeliness may affect our ability to rate a transaction, or potentially cap the rating. | Compensation structure and incentives of different transaction parties can result in conflicting interests, which may not have a strong alignment of interest with noteholders. |
| Bankruptcy risk could be heightened for key transaction parties that exhibit weak governance and internal controls. | Labeling transactions as "ESG compliant" without appropriate oversight and reporting may increase legal and regulatory risk. | ||
| Targeting ESG-related metrics may decrease flexibility in portfolio management decisions and portfolio optimization considerations, resulting in lower yield or increased credit risk. | Several governance-related factors could increase the likelihood of a special-purpose entity entering insolvency proceedings. This might include weak documentation regarding restrictions on an issuer's objects and powers, debt limitations, and independent directors; restrictions on a merger or reorganization; and limitations on amendments to organizational documents, separateness, and security interests over the issuer's assets. | ||
| A successful cyberattack on a key transaction party could disrupt payments to noteholders. | |||
| The inability to replace a key transaction party may increase operational risk in a transaction. | |||
| Failure of a transaction counterparty to comply with documented remedies if its credit quality deteriorates could increase counterparty risk. | |||
| The lack of replacement provisions for interest rate benchmarks could lead to basis risk, reductions in cash flows, and increased legal and regulatory risk. | |||
| Flexibility of key transaction counterparties with respect to definitions, covenants, and performance triggers in the governing documents could lead to release of credit enhancement. | |||
This report does not constitute a rating action.
| Primary Credit Analysts: | Paul Kalinauskas, New York + 1 (212) 438 5408; paul.kalinauskas@spglobal.com |
| Jekaterina Muhametova, London + 44 20 7176 6764; jekaterina.muhametova@spglobal.com | |
| Secondary Contacts: | Matthew S Mitchell, CFA, Paris +33 (0)6 17 23 72 88; matthew.mitchell@spglobal.com |
| Kate R Scanlin, New York + 1 (212) 438 2002; kate.scanlin@spglobal.com | |
| Erin Kitson, Melbourne + 61 3 9631 2166; erin.kitson@spglobal.com |
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