European collateralized loan obligations (CLOs) performance over the past two years has been remarkably positive, as measured by the several key metrics and benchmarks. To ascertain whether CLOs performance is as good as it seems, S&P Global Ratings has also considered two key metrics: the aggregate collateral balance (ACB) and the adjusted collateral principal balance (ACPB), comparing both against each CLOs' target par amount. In particular, these measures over time provide insight into the health of CLO performance, and are gauge of par losses in CLOs. Defaults are not necessarily the cause of par loss in CLOs; rather, in most instances, it is driven by trading activity as it attempts to limit potential further losses and maintain stable par value tests.

The Value Of Par

Generally, at issuance, a CLO notes' proceeds exceed the target par amount, which is the amount that we consider in our initial analysis. Therefore, focusing on the assets' par amount when looking at overall performance is important.

ACB comprises the aggregate principal balance of all collateral debt obligations plus balances on the principal or any other account that may represent principal proceeds, which in some cases may be a negative cash balance. On the effective date, where the portfolio is fully ramped up and any future trading will require meeting the CLO set-out criteria, the CLO ACB will be the same as or exceed the target par amount. From there, the collateral manager will try to ensure that the ACB equals or exceeds the target par, as an ACB below target par would typically be considered as a par loss in the underlying CLO portfolio.

Chart 1 shows the average monthly difference between the ACB and target par, across all S&P Global Ratings rated CLOs. Amounts above the 0 axis indicate ACB above target par (a par gain), while amounts below the 0 axis indicate ACB below target par (a par loss). The chart also includes the monthly cash balance in CLOs (with zero balance being the 0 right axis). Amounts above the 0 indicate a positive cash balance, while those below indicate a negative cash balance. Finally, we show in text the total number of CLOs and those with a par loss in that month.

Chart 1

About 50% of CLOs saw their ACB fall below target par during fourth-quarter 2020, as the previous quarter's defaults, market value reductions, and trading losses started to come into play. In November 2020, 83 out of 166 CLOs had an ACB lower than their original target par. That said, the CLOs in chart 1 also include new issuance and refinancing CLOs, which, in order to become effective, are likely to be at the same level or above target par.

The average notional amount change is quite small, however a relative dispersion suggests some CLOs as having ACBs reduced by a greater amount. If we just focus on the 112 CLOs issued before March 2020 when the effect of the pandemic started to pinch CLOs, 81 of these CLOs saw a par loss by November 2020 at an average of 0.25% compared to an overall average of 0.09% (new issuance and refinancing CLOs included). Additionally, 19 of these 81 CLOs had a par loss of over 1.00% by November 2020, although 45 CLOs remained above target par.

Chart 2 shows how the average monthly difference between the ACPB and target par (with par being the 0 left axis) has changed. Figures above 0 indicate an ACPA above target par (a par gain), while those below indicate that the ACPA is below target par (a par loss). In both cases, the fall or rise indicated is between months. The right axis shows the percentage of notional amounts of assets rated in the 'CCC' or 'nonperforming' rating category. Finally, the number of CLOs and those with a par loss in that month are indicated in text.

Chart 2

Typically, the ACPB comprises the collateral principal amounts plus haircuts for riskier assets--for example, those applied for excess 'CCC'-rated assets above 7.5%, workout loans, and defaulted, discount, deferring, long dated, and zero-coupon obligations.

Collateral managers use the ACPB as the numerator in the par value test, and we commonly use it in our cash flow analysis to assess the excess spread available to a transaction. Keeping above target par is a key aspect of our document review at closing to ensure haircuts are applied and any par leakage is limited to above target par--for example, at the first and/or second payment date, excess principal in the CLO, trading gains, and exercising of warrants. More conditions have emerged for CLOs to leak below target par, with mitigating factors like the use of principal to purchase workout loans. Market participants have also suggested parking interest or other non-principal amounts in the principal account for a short period of time. However, these suggestions raise concerns on causing potential volatility for the ACPB as the numerator in the par value test.

If we look at the same 112 CLOs from March 2020 compared to November 2020, the average ACPB was 0.65%, similar across all CLOs. However, now 42 of these CLOs had a par loss compared to just 19 when looking at the ACB against target par.

Given the additional haircuts applied, as soon as ratings started to migrate to the 'CCC' and nonperforming categories as COVID-19 took hold, the ACPB fell below target par and has remained there, although it is slowly reverting. At the end of 2021, only a few CLOs exceeded 7.5% of 'CCC' rated and nonperforming assets, which would leave the question open as to where else par has been lost over the previous 24 months (see chart 10). With the limited par leakage and falling prices, the other factor to consider for par loss would be trading losses.

Over the past 24 months, collateral managers were navigating strong headwinds to balance their portfolios, with undervalued selling of assets, overpaying on prime assets, or low recoveries on defaulted assets. Although some trades resulted in CLO par reduction, the losses taken at that time likely far outweighed the opportunity cost in holding on to underperforming assets for longer. Each collateral manager has their own way of risk and trading, but they all share the same ultimate goal of protecting par, ensuring that the par value tests are protected at the interest of all parties.

Negative cash balances have increased during the pandemic as collateral managers effectively overtraded their portfolios in a bid to ensure they limit the losses they would have incurred had they remained inactive, negate negative carry as a result of prolonged settlement timings, and potentially take advantage of committing to strong credits at competitive prices. Collateral managers would have also traded undervalued assets into the portfolio during the pandemic which would help balance the par losses, which are now reverting to a par value so helping improve the overall value of the portfolio and limiting long-term negative par loss. As we see from chart 3, the amount of negative cash in CLOs increased, reaching over €6 million on average across all CLOs by the end of 2021.

As we move into 2022 and refinancing of transactions slows, many CLOs will remain in a par loss as prices of primary and secondary market loans continue to increase, making it hard to trade back into a positive amount.

Altogether, the negative effects on the numerator have not caused many par value test breaches, with just six CLOs failing over the past two years with a maximum failure of 111 basis points and a maximum failure period over eight months. Over the same period, two CLOs had more than one par value test failure. Overall, this shows that the approaches collateral managers have taken during the pandemic did indeed help limit par losses and protect the CLO par value tests.

What A Difference 24 Months Can Make

While the start of 2020 brought market volatility and credit deterioration, CLOs so far have weathered the storm as deteriorating portfolio credit quality stabilized, par losses reduced, and record new issuance reflected continued recovery. (We published two reports on the topic--"How COVID-19 Changed The European CLO Market In 60 Days," and "How The European CLO Market Has Developed Over 180 Days Of COVID-19,"--where we discussed how the initial phases of the COVID-19 pandemic had altered the market.)

We recognize that recent events will provide a new challenge to the corporate landscape and that CLOs are also likely to be affected. Russia's military intervention into Ukraine has prompted strong international sanctions, including on large parts of Russia's banking system. The announced sanctions could have significant direct and second-round effects on economic and foreign trade activity, supply-chain dynamics combined with inflationary pressures, consumer confidence, and financial stability.

Over 2020, the effect of the pandemic on the credit quality of the assets in CLOs portfolios was quite evident, with increases of 'CCC' category rated and defaulted assets as well as deterioration of S&P Global Ratings weighted-average rating factor (SPWARF) metrics. As we progressed through 2021, performance levels appeared to have stabilized, and while the average SPWARF is still greater than the pre-pandemic SPWARF, the level of 'CCC' category rated and defaulted assets has reduced. Chart 5 shows how, over the past 24 months, the SPWARF has increased on preexisting CLOs and also those issued since the start of 2020.

Chart 5

Table 1

European CLO Benchmarks
Date	CLO (no.)	Obligor count (no.)	Asset count (no.)	Debt count (no.)	Asset amount (mil. €)	SPWARF	WARR	WAS	'BB-' and ratings above (%)	'B-' ratings (%)	'CCC' category (%)	Nonperforming category (%)	CreditWatch negative (%)	Negative outlook (%)
Jan-20	98	604	852	21,279	39,453	2,690	37.85	3.80	11.59	18.40	2.78	0.11	1.01	21.06
Feb-20	104	629	899	22,382	41,863	2,705	37.71	3.79	11.32	18.94	2.65	0.11	0.83	19.15
Mar-20	115	641	938	25,036	46,396	2,691	38.10	3.78	11.05	19.51	1.81	0.07	0.88	18.44
Apr-20	111	630	924	24,108	44,731	2,786	37.53	3.76	10.82	18.83	5.74	0.09	5.02	28.17
May-20	118	638	908	25,789	47,488	2,914	37.29	3.76	9.85	22.73	9.64	0.13	6.75	37.20
Jun-20	132	658	927	28,481	52,547	2,898	37.47	3.77	10.61	24.97	8.82	0.23	6.82	39.37
Jul-20	134	660	934	28,908	53,622	2,916	36.60	3.77	10.24	25.35	9.22	0.25	7.35	40.51
Aug-20	136	665	950	30,483	54,458	2,887	37.68	3.79	10.04	25.66	7.79	0.58	7.33	40.29
Sep-20	140	638	925	31,248	55,235	2,886	37.12	3.80	9.87	25.66	7.45	0.49	7.11	40.17
Oct-20	146	660	947	32,447	57,257	2,873	37.17	3.81	9.94	25.00	7.27	0.69	5.18	39.31
Nov-20	149	675	971	33,795	58,633	2,854	37.13	3.81	10.90	25.80	6.46	0.69	4.20	38.18
Dec-20	151	682	993	34,466	59,060	2,867	37.00	3.81	11.08	23.79	7.55	0.55	3.32	37.52
Jan-21	160	692	1,022	40,527	65,783	2,877	36.92	3.82	11.52	24.51	7.34	0.29	3.03	35.99
Feb-21	170	686	1,007	40,249	64,603	2,869	36.92	3.82	11.95	23.60	7.37	0.11	0.97	36.54
Mar-21	173	692	1,022	40,527	65,783	2,876	36.87	3.82	12.00	23.59	6.81	0.14	1.02	35.26
Apr-21	172	696	1,040	41,891	65,573	2,891	36.76	3.79	12.25	23.98	6.11	0.46	0.45	28.84
May-21	169	693	1,041	40,936	63,850	2,874	36.73	3.79	12.08	24.29	5.41	0.42	1.14	26.71
Jun-21	170	711	1,060	41,719	65,082	2,880	36.58	3.78	12.06	24.75	5.26	0.35	1.11	21.90
Jul-21	172	704	1,031	42,317	66,436	2,889	36.34	3.78	11.49	24.52	5.43	0.34	0.50	18.62
Aug-21	175	714	1,061	43,647	68,373	2,894	36.22	3.75	11.53	23.95	5.04	0.59	0.36	16.97
Sep-21	180	713	1,041	44,570	70,282	2,887	38.00	3.75	11.31	23.53	5.16	0.43	0.37	16.41
Oct-21	191	713	1,021	46,601	74,800	2,893	37.60	3.76	11.43	23.46	4.84	0.40	0.17	14.59
Nov-21	200	707	1,015	50,028	78,841	2,893	36.09	3.76	11.54	23.88	4.62	0.35	0.05	13.15
Dec-21	221	730	1,067	57,061	87,544	2,903	36.07	3.76	11.56	23.62	5.24	0.30	0.30	12.10
Jan-22	220	730	1,076	57,472	88,450	2,883	36.06	3.77	11.39	23.30	4.63	0.20	0.29	11.99
SPWARF--S&P Global Ratings weighted-average rating factor. WARR--'AAA' weighted-average recovery rate. WAS--Weighted-average Ssread (net of floor).

New issuance volume of CLOs that we rate has increased over the past two years, with the number of obligors and assets available also increasing over the period, allowing warehouses to open and purchase in mass.

Our recovery rate expectations have continued to fall consistently over the period, while other key benchmarks have instead improved slightly, such as the reduction of negative bias as negative CreditWatch and outlook placements have decreased from record highs in CLO 2.0 transactions (issued from 2013). Overall however, the long-term effect remains to be seen.

European CLOs Continue To Perform Well

The end of 2021 saw only one outstanding tranche of an S&P Global Ratings rated CLO 1.0 (those issued before 2013). The performance has been noteworthy, with only 1.5% of defaulted tranches in total since the first CLO was issued and no defaults for the 'AAA', 'AA', and 'A' category tranches. Even the 'BBB' category tranches saw just four tranches defaulting, out of 288 tranches issued with an original rating in the 'BBB' category.

After eight years, CLO 2.0 transactions are also performing in line with their predecessors. The addition of features such as greater credit enhancement, shorter reinvestment periods, and tighter eligibility criteria (for example, no structured finance assets or synthetic positions) has bolstered performance, leading to more focus on corporate debt only and the presence of risk retention requirements. Overall, these are positive characteristics for current CLOs.

Table 2

Default Summary By Original Rating For European CLOs
As of Dec. 31, 2021
	CLO 1.0			CLO 2.0
Rating	No. of original ratings	No. of defaults	Currently rated	No. of original ratings	No. of defaults	Currently rated
AAA	472	0	0	645	0	394
AA	222	0	0	693	0	466
A	239	0	0	452	0	294
BBB	288	4	0	419	0	272
BB	205	17	1	393	0	269
B	11	1	0	345	0	256
Total	1,437	22	1	2,947	0	1,951
Source: S&P Global Ratings Research.

Attention to inflation by the end of 2021 and central banks bringing forward their monetary policy tightening to curb it will likely result in wider pricing in 2022, and will probably lead to a preference for floating-rate instruments, rather than fixed-rate or longer duration debt. Debt repricing may pause, while debt from mergers and acquisitions will significantly boost issuance volume in 2022 (see "European Leveraged Finance And Recovery Q4 2021 Update: Finishing On A High," published Feb. 8, 2022).

That said, we expect the 12-month trailing European speculative-grade corporate default rate to rise to 2.5% by December 2022 compared to 1.8% in December 2021, with the optimistic scenario being a fall to 1.0% by December 2022, as we anticipate a subdued default rate during 2022 (see "The European Speculative-Grade Corporate Default Rate Could Rise To 2.5% By December 2022," published on Feb. 22, 2022).

Table 3

Rating Actions On Original Rated European CLO 2.0 Transactions Since March 2020
	Reinvesting European CLO 2.0 CreditWatch Negative Resolutions			Amortizing European CLO 2.0
Rating category	Affirmed	One-notch downgrade	Two-notch downgrade	One-notch Upgrade	Multiple-notch upgrade	Downgrade	Total no. of actions
AAA	-	-	-	-	-	-	-
AA	-	-	-	4	1	-	5
A	-	-	-	5	-	-	5
BBB	4	3	-	1	-	-	8
BB	8	17	2	-	1	1	29
B	2	3	-	-	1	1	7
Total	14	23	2	10	3	2	54

After the beginning of the pandemic, we placed 39 tranches on CreditWatch negative during 2020. Worsened portfolio credit quality and factors such as reduced par and excess spread resulted in two tranches being downgraded by two notches, 23 tranches being downgraded by one notch, and 14 affirmations. However, as CLOs came out of their reinvestment periods, they were able to achieve higher ratings thanks to increases in credit enhancement, even with worsened credit quality, which resulted in four tranches being upgraded by more than one notch and nine tranches being upgraded by one notch. Overall, CLOs withstood stresses during the pandemic as they have been designed to do, resulting in only 1.25% of our rated CLOs experiencing a rating action over the past two years.

The Pandemic's Effect On European Speculative-Grade Companies

Many of the negative rating actions we took on corporates and sovereigns globally over the past two years related to COVID-19 (negative rating actions include outlook revisions to negative, CreditWatch negative placements, and downgrades).

The quarter-on-quarter evolution of our issuer credit ratings (ICRs) on European speculative-grade companies reflects a wave of negative rating actions during 2020 across several sectors, geographies, and products. This wave began to reverse during 2021, with outlook revisions and upgrades increasing.

Chart 7

European CLOs over the past two years have been backed by debt issued by between 35%-39% of these rated European speculative-grade companies. The percentage of companies with assets in CLOs on which we took rating actions is similar to that of companies not backing CLOs, which indicates that CLOs continue to invest in a range of sectors, geographies, and products.

Over the past two years, the rating breakdown for corporate assets contained in CLO portfolios evolved in this way:

Chart 9 shows how corporate rating transitions in CLO portfolios have affected 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/Watch Neg' as a 'B-' rating in our CLO analysis.

These are average figures and display a large dispersion. They are also based on the latest trustee report available as of the rating action. We are continuing to see the effect of actions that each portfolio manager took to counterbalance the wave of negative rating actions, including reductions in the 'CCC' and nonperforming buckets.

Chart 10 shows the rating category evolution in the CLOs we rate, indicating the distribution by percentage of notional amount in CLOs exposed to 'B-' rated, and 'CCC' and 'D' rating categories for each day compared with the SPWARF.

At the same time, not all CLOs are structured the same. For example, higher credit enhancement, higher overcollateralization triggers, or even better economic arbitrage may allow some CLOs to perform better.

What Do The Other Metrics Indicate?

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," we assume continued stable performance for CLOs 2.0.

However, challenges remain, including higher leverage ratios, EBITDA add-backs, and covenant-lite loans. Even considering these, our recovery expectation is still slightly lower than 55% in CLOs, which is much lower than the historical recovery average of 73%, but typically much higher than what transaction documents have in their covenants for 'AAA' rated CLO tranches.

Generally, recovery ratings for CLOs have remained largely unchanged, mainly being in the '3' range. However, we have also seen migration from the '2' and '4' range into this space to see a more compacted '3' range, with 3(60%) remaining on average the highest percentage, but 3(50%) and 3(55%) gaining ground.

Breaking it down by industry and geography, over the past two years there have been clear movements by percentage of notional amounts into and away from certain industries and countries to others, given how the ratings and markets have evolved over the same period (see charts 12 and 13).

The Year Ahead

We had anticipated that rating actions on corporate issuers would continue to be rating neutral, with the stabilization of outlooks continuing and negative outlooks across speculative-grade corporate issuers reverting to pre-pandemic status.

However, we acknowledge a high degree of uncertainty about the extent, outcome, and consequences of the military conflict between Russia and Ukraine. Irrespective of the duration of military hostilities, sanctions and related political risks are likely to remain in place for some time. Potential effects could include dislocated commodities markets--notably for oil and gas--supply chain disruptions, inflationary pressures, weaker growth, and capital market volatility. As the situation evolves, we will update our assumptions and estimates accordingly. See our macroeconomic and credit updates here: Russia-Ukraine Macro, Market, & Credit Risks. Note that the timing of publication for rating decisions on European issuers is subject to European regulatory requirements.

Currently, our ICRs on five corporate obligors present in CLOs remain on CreditWatch negative.

When comparing the few CLO downgrades to the significant number of negative corporate rating actions that affect them, we believe CLOs have shown resilience over the past two years given their features to cover a decrease in credit quality and excess spread.

We acknowledge that the pandemic is not over. Many collateral portfolios still have credit quality concerns and many CLOs remain below par, so collateral managers have their work cut out to bring CLO performance back to pre-pandemic levels. However, with refinancing and trading gains now occurring, a more stable ratings outlook, and new assets remaining available, collateral managers will have their chance to flex their muscles to ensure CLOs remain a stable investment.

Ongoing European CLO Updates

In response to investors' growing interest following the COVID-19 pandemic and ongoing credit effects on companies and European CLOs, we are publishing a regularly updated list of the rating actions we have taken globally on nonfinancial corporations that have had an effect on CLOs, and a summary of how CLOs have been affected with key benchmarks.

The report, titled "Weekly European CLO Update," covers all currently S&P Global Ratings' rated CLOs, including those that are in their reinvestment period. The rating actions and benchmarks are refreshed weekly to provide an update of the CLO market.

To compare European CLO data each week, we provide an EMEA CLO Collateral Managers Dashboard. This dashboard is a single snapshot view of CLO-critical credit risk factors where you can examine, compare, and benchmark individual S&P Global Ratings' rated CLOs.

https://www.spglobal.com/ratings/en/research-insights/topics/powerbinew

Additionally, our quarterly pulse series provides an update of the European CLO market. See the latest published report here: "CLO Pulse Q3 2021: Sector Averages Of Reinvesting European CLO Assets," published on Feb. 4, 2022.

The rapid spread of the omicron variant highlights the inherent uncertainties of the pandemic as well as the importance and benefits of vaccines. While the risk of new, more severe variants displacing omicron and evading existing immunity cannot be ruled out, our current base case assumes that existing vaccines can continue to provide significant protection against severe illness. Furthermore, many governments, businesses, and households around the world are tailoring policies to limit the adverse economic impact of recurring COVID-19 waves. Consequently, we do not expect a repeat of the sharp global economic contraction of second-quarter 2020. Meanwhile, we continue to assess how well each issuer adapts to new waves in its geography or industry.

Appendix

In this report, we included all S&P Global Ratings rated European CLOs issued during 2020 and 2021 where a trustee report has been provided for the month, including those which are both in their reinvestment and amortizing period.

Related Criteria And Research

• Weekly European CLO Update, March 7, 2022
• The European Speculative-Grade Corporate Default Rate Could Rise To 2.5% By December 2022, Feb. 22, 2022
• European Leveraged Finance And Recovery Q4 2021 Update: Finishing On A High, Feb. 8, 2022
• CLO Pulse Q3 2021: Sector Averages Of Reinvesting European CLO Assets, Feb. 4, 2022
• The Macro And Credit Effects Of Russia’s Invasion Of Ukraine, Feb. 25, 2022
• Ratings Recap Of October 2020 European CLO CreditWatch Resolutions, Oct. 13, 2020
• How The European CLO Market Has Developed Over 180 Days Of COVID-19, Sept. 2, 2020
• Ratings Recap Of August 2020 European CLO CreditWatch Resolutions, Aug. 18, 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
• How COVID-19 Changed The European CLO Market In 60 Days, May 6, 2020
• European CLOs: Assessing The Credit Effects Of COVID-19, March 25, 2020
• Global Methodology And Assumptions For CLOs And Corporate CDOs, June 21, 2019

Primary Credit Analyst:	Shane Ryan, London + 44 20 7176 3461; shane.ryan@spglobal.com
Secondary Contacts:	Emanuele Tamburrano, London (44) 20-7176-3825; emanuele.tamburrano@spglobal.com
	Sandeep Chana, London + 44 20 7176 3923; sandeep.chana@spglobal.com