Interest in private credit and middle-market (MM) collateralized loan obligations (CLOs) has grown significantly in recent years. In 2021, interest was driven by investors' search for yield and relative value amidst a booming CLO market, but also by the strong rating performance of MM CLOs during the COVID-19 pandemic. During the economic dislocation of 2020, MM CLOs saw just 1.3% of their outstanding tranche ratings lowered by S&P Global Ratings (seven out of 553 outstanding at the time) compared to about 12.4% (471 out of 3,786) for broadly syndicated loan (BSL) CLO ratings. Loans in MM CLOs have performed well in the aftermath of the pandemic, with companies in some sectors still benefiting from the tailwinds of COVID-19 recovery even in the face of macroeconomic issues like inflation and rate hikes. Credit estimate upgrades in 2022 through the third quarter continue to outpace downgrades by a ratio of 1.57 to one, compared to 1.3 to one for all of 2021. Improved earnings and better balance sheets have seen many MM companies becoming candidates for upgrades (see "Middle-Market CLO And Private Credit Quarterly: Calm Amidst the Storm?" published Oct. 13, 2022). Looking forward, however, the current slowdown in economic growth, coupled with inflationary pressures and rising interest rates--and the consequent pressure on corporate margins--could weigh heavily on companies with high leverage and low interest coverage ratios.

How would MM CLO ratings perform if they were subjected to another downturn, or one that was more severe than the 2020 recession? To answer that question, we applied a series of five hypothetical stress scenarios to a sample of 60 of our rated MM CLO transactions still within their reinvestment periods, generating quantitative analysis for each one using our CLO rating models (CDO Evaluator and S&P Cash Flow Evaluator). The first four scenarios feature increasing levels of collateral default stress, while the fifth scenario assumes that all 'ccc' category obligors default with a 50% recovery and all 'b-' obligors are lowered to a credit estimate of 'ccc+'. As with our previous stress scenario analysis of MM CLO ratings (see "Scenario Analysis: How Resilient Are Middle-Market CLO Ratings?" published Feb. 26, 2021), the stress scenarios outlined in this article show the fundamentals of the CLO structure protecting the noteholders, especially for the senior CLO tranches, and that MM CLOs can withstand comparable asset defaults with less impact on the CLO ratings than BSL CLOs.

Some Differences Between MM And BSL CLOs

MM CLOs are a segment of the U.S. CLO market backed by senior secured loans to smaller companies, typically those with EBITDA of $100 million or lower (and often much lower). They represent about 15% of total S&P Global Ratings-rated U.S. CLOs by par value of the assets, and slightly less by transaction count. They have seen strong issuance over the past five years (2017-2021), although in 2022 year-to-date (through the third quarter), issuance has been much lower both in absolute terms and as a proportion of overall CLO new issuance volume (see table 1).

Table 1

Unlike BSL CLOs, where S&P Global Ratings has a rating on more than 95% of the companies issuing the loans held within the CLO collateral pools, most MM CLOs contain a significant proportion of loans from smaller companies that aren't rated. We typically use credit estimates to assess these unrated companies for the purpose of our MM CLO analysis (see "Anatomy Of A Credit Estimate: What It Means And How We Do It," published Jan. 14, 2021). The proportion of loans from credit-estimated versus rated companies varies significantly from one MM CLO to another, but MM CLOs overall, have a much higher proportion than BSL CLOs.

MM CLOs have more exposure to loans from obligors with lower credit quality than do BSL CLOs; companies in MM CLOs tend to be smaller than those in BSL CLOs. As of third-quarter 2022, the average U.S. BSL CLO exposure to loans from companies rated 'B-' and 'CCC' category was about 29% and 4.4% of total assets, respectively; the proportion of MM CLO exposure to issuers credit estimated 'b-' and 'ccc' category was about 74% and 9%. In addition to having a lower-quality credit profile, most MM CLO portfolios tend to have lower diversity, shorter average tenor of the loan collateral, and higher loan spreads relative to BSL CLO portfolios. However, while there is less diversification within MM CLO collateral pools, there is much greater diversification across MM CLOs issued by different managers, as MM CLO loans are often unique to a single collateral manager.

MM CLOs also tend to have more par subordination for their rated tranches than BSL CLO transactions. There is significant variance in transaction structures, with some MM CLOs having just two tranches (a senior rated note and equity) and others looking more like a BSL CLO structure, with notes issued from 'AAA' down through 'BB' (and sometimes even a 'B'). Additionally, the variance in subordination at each CLO tranche rating category is much wider for MM CLOs than for BSL CLOs (see table 2 below).

Table 2

Generating The MM CLO Rating Stress Scenarios

We produce rating stress scenarios for our rated CLOs periodically to assess how they might perform under different economic scenarios. The default rate across MM CLO portfolios in a significant downturn would potentially be correlated by the manager, in our view, as many loans within MM CLO portfolios are specific to a single manager. For our stress runs, to maintain consistency across the sample for our first four scenarios, we assumed each portfolio experiences the same default level, which are applied with increasing levels of asset default stress to see how the CLO ratings would respond. This is different from the approach we use for our BSL CLO rating stress analysis, where we sort the performing companies from weakest to strongest (first by rating, and then by loan price) and then hit the stress scenario default targets by starting at the bottom and working our way up, with specific asset defaults within each CLO varying by their exposure to the companies we assumed would default.

In the fifth and final scenario below, the stress is dependent on the current credit profile of the companies within each portfolio. For all of our runs, we excluded CLO combo notes and X notes from the analysis. Our sample included 60 MM CLOs that are scheduled to reinvest for all of 2022. There was a wide range of structures as well as portfolios, with some of the portfolios being something of a hybrid of both MM and BSL assets.

Our specific stress assumptions were:

• Scenario One: 10% of the assets default with a 50% recovery;
• Scenario Two: 15% of the assets default with a 50% recovery;
• Scenario Three: 20% of the assets default with a 50% recovery;
• Scenario Four: 30% of the assets default with a 50% recovery; and
• Additional Scenario: assume every obligor with a current credit estimate in the 'ccc' range defaults, and that every 'b-' credit-estimated obligor is lowered by one notch to 'ccc+'.

Chart 1 shows a summary of the scenarios and their ratings impact.

Chart 1

None of the above scenarios are meant to be predictive of any specific outcome for the collateral within CLO transactions, or for the most stressful scenarios to even be particularly plausible. But we think the hypothetical scenarios provide insight into how MM CLO ratings might respond to varying stress levels. By setting up the first four scenarios in the way we have, with a simple progression of increasingly severe assumptions, we hope to allow CLO investors and others to make their own view amongst the four scenarios and gauge the potential CLO rating outcome. The fifth stress scenario was added to address questions we've gotten from market participants.

Differences between MM and BSL CLO stress scenarios

There are some differences between our MM and BSL CLO stress scenarios in terms of our assumptions for default rates and rating transition on the non-defaulting loans.

Compared to the rating stress scenarios we published a few months back for our rated BSL CLO transactions in "How The Next Downturn Could Affect U.S. BSL CLO Ratings (2022 Update)," published Aug. 4, 2022, the default rate assumptions we use here are more punitive (10%, 15%, 20%, and 30% of CLO assets defaulted for this exercise, versus 5%, 10%, 15%, and 20% for the BSL CLO rating stress article) due to the differences in rating/credit estimate profiles for MM and BSL CLO transactions. Note that the more stressful default scenarios outlined in this article, like the 20% default scenario in the BSL CLO rating stress article, are well outside the range of default forecasts, but we include them as interesting hypotheticals.

Another difference is that for the first four scenarios in this article, unlike the ones we used in the August 2022 BSL study, we did not assume any rating transition on the non-defaulting loans in the CLO collateral pools because a large majority of MM CLO collateral is already rated (or credit-estimated) at 'b-' or lower. For the purpose of this exercise, we assumed a 50% recovery rate for the loans we're defaulting, versus a 45% assumption for the August 2022 BSL CLO rating stress article. While this may seem counterintuitive at first--as one might expect lower recovery prospects from loans to smaller companies--it makes sense when we consider the fact that loans in MM CLOs are generally not covenant lite, and they tend to have more constrictive loan document provisions than loans held in BSL CLOs, especially for companies further down the EBITDA scale.

MM CLO structures vary more than BSL CLO structures

As noted earlier, MM CLO structures vary more than BSL CLO structures, both in terms of average par subordination for a given tranche and in which tranches are included in a given MM CLO structure. About half of our sample consisted of MM CLOS that include junior tranches (defined here as tranches with initial ratings in the 'BB' or 'B' categories). These tend to be MM CLOs that include a greater proportion of BSL loan collateral alongside their MM loan collateral, and unsurprisingly, they have structures more akin to what you would see in a BSL CLO, with lower-rated tranches. They also tend to have lower (that is, more BSL CLO-like) subordination levels, in particular, for tranches initially rated in the 'AA' through 'BBB' categories (see table 3 below). For example, across MM CLOs issued with only investment-grade notes, the average 'BBB' tranche par subordination was 19.4%, compared to 17.9% for MM CLOs issued with speculative-grade CLO notes.

Table 3

In the Appendix section, we provide the results of the stress scenarios broken out across these two cohorts.

Some limitations and caveats to our testing

For purposes of our scenario testing, we generated a quantitative analysis for our sample CLOs using the same tools we use when rating the transactions. Our CDO Evaluator credit model assesses the overall credit quality of a portfolio of assets based on the rating and maturity of each asset, as well as the correlation between assets, and produces expected asset default rates at stresses commensurate with our various CLO rating levels. Our S&P Cash Flow Evaluator model, on the other hand, is used to assess the ability of the tranches in a given CLO to withstand loss rates under various interest rate and default timing scenarios (see "S&P Global Ratings' CLO Primer," published Sept. 21, 2018). While ratings are assigned by committee and our criteria encompass a variety of qualitative and quantitative components, looking at the output of these two models for a given CLO portfolio and structure should provide an indication of the ratings a surveillance committee might assign following a given stress scenario.

Also, a few caveats worth highlighting:

• The stresses we selected for the scenarios are hypothetical and not meant to be predictive or part of any outlook statement.
• The stresses we selected aren't meant to calibrate to any of the economic scenarios we associate with our ratings.
• The stresses were applied at time zero in the analysis; in reality, defaults would occur over a longer time span, giving the overcollateralization (O/C) tests time to pay down some of the senior CLO note balances and replenish some of the senior tranche credit enhancement.
• The results are based on the application of the models we use to rate CLOs; a rating committee applying the full breadth of our criteria and including qualitative factors under our criteria might in some instances assign a different rating than the quantitative analysis would indicate.

The Results Of The Stress Scenarios

Table 4 shows the results of the stress scenarios.

Table 4

As expected, the results of the first four scenarios showed more rating impact as the proportion of defaults increased to 30% from 10%, similar to what we saw in our study last year where we applied the same scenarios. Since then, the sample used in this study now includes CLOs issued in 2021, after the worst of the pandemic downturn had passed. Despite the change in sample, the median subordination levels at each rating category remained fairly close to those of last year. As a result, the average notch impact of these four scenarios were fairly similar to last year's results, particularly for the investment-grade tranches.

The 'BB' category transitions are unique to the transactions that have speculative-grade tranches within the capital structure, which tend to have slightly less subordination relative to the transactions that only issue investment-grade tranches. As expected, we see the transactions with less subordination tend to see a higher average transition under each of these scenarios (see Appendix).

Despite the median tranche subordination remaining fairly similar, the credit quality of the MM CLO portfolios has changed notably since last year. Relative to the sample used in our February 2021 study, the average 'ccc' category asset exposure of our current sample declined significantly, along with a modest increase in loans from 'b-' companies. This has a notable impact on the final scenario where we assume all current 'ccc' assets default with 50% recovery, while all 'b-' exposures get downgraded. As expected, the average transition for this scenario is much smaller relative to what we reported last year.

Study Conclusion: The Fundamentals Of The MM CLO Structure Continue To Prove To Be Resilient Against Shocks

As with the BSL CLO rating stress analysis we published in August 2022, the analysis outlined in this article shows the fundamentals of the MM CLO structure protecting senior noteholders, with more than 97% of CLO 'AAA' tranche ratings either experiencing an affirmation or a one-notch downgrade to 'AA+' even under our most punitive scenario (30% of the obligors are immediately defaulted).

Outcomes for tranches further down the CLO capital stack depend upon the severity of the assumptions applied, but no tranche rated 'A' or higher defaulted under any of our scenarios. We note that the 'AAA' CLO tranche downgrade rate in the real world would likely be lower than indicated in the stress test transition tables above. This is because rating committees sometimes take into account qualitative considerations, our expectations for future senior tranche pay downs, and other factors beyond the results of the quantitative analysis done for this article.

Appendix: Stress Scenario Results Broken Out By MM CLOs With And Without Junior Tranches

Tables 5 shows the results of the stress scenarios broken out across MM CLOs issued without and with junior tranches.

Table 5

Related Research

• Middle-Market CLO And Private Credit Quarterly: Calm Amidst the Storm? Oct. 13, 2022
• How The Next Downturn Could Affect U.S. BSL CLO Ratings (2022 Update), Aug. 4, 2022
• Scenario Analysis: How Resilient Are Middle-Market CLO Ratings? Feb. 26, 2021
• How COVID-19 Affected U.S. Middle-Market And BSL CLO Performance In 2020, Feb. 4, 2021
• Anatomy Of A Credit Estimate: What It Means And How We Do It, Jan. 14, 2021
• Credit Estimates For Entities Backing U.S. Middle-Market CLOs Took A Hit From COVID-19, Dec. 1, 2020
• S&P Global Ratings' CLO Primer, Sept. 21, 2018