The post-pandemic environment, the military conflict between Russia and Ukraine, rising inflation and interest rates, and budget policies have led to increased volatility in the European collateralized loan obligation (CLO) market, to an extent that was not seen even during the pandemic, when asset prices managed to recover after dropping sharply. In 2022, price movements fluctuated over relatively small periods of time, EURIBOR rates increased, and spreads widened, presenting collateral managers with the opportunity to improve par and/or other key benchmarks in many transactions.

For this report, S&P Global Ratings provides an overview of all par losses and gains--plus improvements in other key benchmarks--experienced in CLOs over the course of 2022 where a monthly trustee report was provided. Our analysis considers all CLOs rated by us and issued before 2022 that were in their reinvestment periods.

It's All About The Par

Chart 1

After normalizing target par at €400 million for the 195 CLOs included in this analysis, par reduced only during April and September 2022, while all other months of the year saw a par gain. A small number of CLOs had par losses of over €3 million in a single month, while a handful of CLOs gained over €2 million of par in a month. Overall, as an aggregate average, nearly €0.85 million was gained by CLOs in 2022. To better understand what exactly par value creation means in the context of CLOs, we outlined two key definitions considered in CLO documentation: the aggregate collateral balance (ACB) and the adjusted collateral principal balance (ACPB).

Chart 2

Please see appendix for a description of the calculation.

2022: The Year Of Par?

Of the 195 CLOs we considered for this report, 41 saw a par reduction and 154 gained par based on the ACB between the start of 2022 and the end of the year. Over the same period but based on the ACPB, 81 CLOs experienced par loss and 114 par gain. The ACB change range is between a 0.65% loss and 1.19% gain, while for the ACPB the range was 1.36% loss and 1.45% gain. On average, there was a 0.21% gain by ACB and a 0.01% gain by ACPB (see chart 3).

If we look at the breakdown by collateral managers, nine lost par and 45 gained par based on ACB, while 22 lost par and 32 gained par based on ACPB in 2022. By taking the average across the transactions each one manages, the ACB and ACPB change ranged between 0.42% loss and 0.79% gain, respectively (see table 1).

Chart 3 shows the average percentage monthly difference between the ACB and target par along with the monthly difference between the ACPB and target par for the 195 S&P Global Ratings rated CLOs that could reinvest during the whole of 2022. Given that transactions that closed from late 2021 would be at target par compared to older transactions--which may have gained or lost par already--our starting point in January 2022 has an average above 100%. As the year progressed, the ACB gains ranged between 100.13% and 100.35%.

Perhaps unsurprisingly, the trajectory for ACPB trended more conservatively during the year, largely driven by challenging market conditions, making its presence felt through haircuts on the riskier asset balances.

Chart 3

When looking at the various elements that comprise ACPB, three stand out as the main performance drivers in 2022--excess 'CCC'-rated assets above 7.5%, defaulted assets, and discount obligations.

Over 2022, the S&P Global Ratings' weighted-average rating factor (SPWARF) remained broadly unchanged, as any downgrades in underlying CLO names were mitigated by asset purchases with offsetting characteristics. However, over the same period our data set highlights that in the final quarter of 2022 the proportion of CLOs whose 'CCC' buckets were above 7.5% increased nearly two-fold, resulting in an increased number of CLOs carrying these assets at market value under the ACPB. The effect of rating migrations is therefore an important aspect to note, in our view, given that as the SPWARF worsens, the ACB appears to increase while the ACPB decreases (see charts 4 and 5).

Chart 4

Chart 5

The focal point in chart 4 is the top right quadrant, which indicates that most CLOs in 2022 gained par based on ACB but also increased their SPWARF: on average, a 1% increase in ACB is related to a 20 basis point (bps) rise in SPWARF. As such, a collateral manager could, on average in 2022, build €0.85 million of par at the "cost" of a five bps increase in SPWARF. By looking at the top CLOs for ACB gains, Hayfin V DAC stayed broadly unchanged on its SPWARF, Madison Park Euro Funding VIII DAC outperformed by decreasing SPWARF by nearly 100 bps, and Carlyle Global Market Strategies Euro CLO 2015-1 DAC increased by 45 bps. Among the CLOs with the highest ACB reduction, there are three RRE CLOs with increases in SPWARF between 17 bps and 41 bps, showing that not all CLOs demonstrate the same pattern. Overall, although there is a distinct trend in CLO performance, management styles may differ between CLO platforms.

Chart 5 data is concentrated toward the top left quadrant, which refers to a loss of ACPB as SPWARF increases: a 1% decrease in ACPB corresponds to a 60 bps rise in SPWARF. Therefore, a collateral manager could, on average in 2022, build €0.85 million of ACPB at a cost of a 15 bps increase in SPWARF.

Our analysis highlights that (i) a rise in defaulted assets, which are carried at the lower of their market value and rating agency recovery rate (S&P collateral value) as a result, and (ii) a rise in CLOs that hold more than 7.5% of 'CCC' rated assets, in which excess amounts are carried at their market value as a result, have been the dominant drivers of the fall in ACBP (see charts 6 and 7).

Chart 6

Chart 7

Overall, credit quality worsened in 2022, with the SPWARF being 40 points higher on average, one in five CLOs having excess 7.5% 'CCC' buckets, and one-in-three CLOs with defaulted assets. With the increase in these buckets, collateral managers have also had to make calls on working out defaulted assets to receive recoveries later in the transaction's life, or potentially lose par by not being part of the workout or trading out of the asset at a reduced market value.

CLO Managers Built Par While Preserving Credit Quality Through Their Reinvestment Criteria

The lack of mark-to-market triggers better equips CLOs to better withstand market volatility in comparison to other fixed-income products (and, to a degree, compared against their position under a warehouse facility). In the past, when bouts of volatility occurred in the market, this presented CLOs with the opportunity to purchase good quality assets at opportunistic prices.

During the pandemic, for example, collateral managers navigated strong headwinds to balance their portfolios, either by (i) selling assets ahead of crystallizing losses as a result of defaults or otherwise further decreases in asset prices, (ii) purchasing safer assets at opportunistic prices, or (iii) achieving the highest recovery possible from defaulted assets. In 2022, the landscape changed, with impacts from the military conflict between Russia and Ukraine, rising inflation and interest rates, and budget policies leading to higher market volatility that allowed for higher potential trading opportunities in the secondary markets.

Following a period of relative stability in 2021, reinvesting CLOs exhibited declining asset prices during 2022, including several volatile periods of declines.

Chart 8

During the course of 2022, however, collateral managers were more active in trading their portfolio, as they were able to identify opportunistic trades at discounted prices. Arguably, this also presented the opportunity to build par in CLOs and/or improve key benchmarks such as the SPWARF, weighted-average life (WAL), and weighted-average spread (WAS).

Chart 9

Our dataset shows that in 2022, just over €5 billion worth of assets were traded, with €2 billion in sales and €3 billion in purchases. There were slight spikes in trading in the first quarter, with the start of the Russia-Ukraine conflict leading to an uptake of purchases as prices fell. Similarly, in the fourth quarter, the U.K. "post mini budget" fallout saw a vast wave of market activity, with over 50% of the year's trades occurring in November and December as prices fell to below 90 on average.

There were several key purchases, with assets not previously seen in CLO portfolios, offering good relative value at large volumes and trading at attractive prices to relative value (i.e. higher quality ratings and wider spreads).

Notably, the following purchases stand out from our dataset in this regard, which has resulted in CLOs positioning themselves for pockets of opportunity and building par:

• Emeria SASU (France/Real Estate Management) €86 million at an average price of 95;
• Neptune BidCo US Inc. (USA/Media) €83 million at an average price of 89;
• Entain Holdings (Gibraltar) Ltd. (UK/Hotels) €69 million at an average price of 97; and
• Sam Bidco S.A.S. (France/Healthcare Equipment) €63 million an average price of at 98.

Of existing assets in CLO portfolios, we identified a large volume of purchases in the following:

• Barentz Midco B.V. (Netherlands/Chemical) €40 million at an average price of 96;
• Altice Europe S.A. (France/Diversified Telecommunication) €20 million at an average price of 95; and
• Casper BidCo SAS (France/Hotels) €19 million at an average price of 92.

Finally, there were several key sales of assets with high prices, enabling managers to improve other benchmarks as they generated low spreads in the current market environment:

• Entain Holdings (Gibraltar) Ltd. (UK/Hotels) €27 million at an average price of 100;
• Sam Bidco S.A.S. (France/Healthcare Equipment) €20 million at an average price of 93;
• Financiere Mendal SAS (France/ Healthcare Equipment) €17 million at an average price of 99; and
• INEOS Finance PLC (UK/Chemicals) €16 million at an average price of 99.

Under the reinvestment conditions, the credit-improved or discretionary sales processed are typically used to maintain par of the substitute assets. By substituting for the same par, managers can sell a stable low spread asset and substitute it for undervalued assets. At the same time, any unscheduled proceeds could be invested in these undervalued assets or limited primary assets. Thirdly, mangers can typically go into the red in the principal accounts to build up par above the CLO's target par. Given this, trading allows managers to gain par via numerous methods.

Please see appendix for a description of reinvestment conditions.

Is Par All That CLOs Need To Perform?

Par is just one component of how we analyze the performance of a transaction's cash flows, and may not necessarily be the main consideration for the collateral manager when performing portfolio adjustments. That said, market-driven opportunities such as those observed in 2022 present CLOs with unique chances to help support the performance of their portfolios, and at times with offsetting characteristics.

Given that CLOs essentially act as non-mark-to-market facilities with fixed, long-term capital, include call optionality and the ability to reinvest proceeds, this allows collateral managers to protect the performance of their portfolios over the long-term.

Below, we provide several key benchmark changes from the start to the end of 2022 by collateral manager, each of which has its own style of managing CLOs and focusing on key benchmark metrics. This can be seen below with some examples of collateral managers with multiple CLOs:

• Managers (AlbaCore and Redding Ridge) who saw par erosion based on ACB during the past year, have managed increases in bond buckets, minor increases in SPWARF, no defaults, no additional haircuts, and a spread increase for their portfolios.
• Managers (Credit Suisse, Carlyle, and Hayfin) who gained the most par based on ACB during 2022 had a mixture of key benchmark changes, including increased WAS, the lowest decreases in WALs among all CLOs, and average changes across the other benchmarks.

Overall, in 2022, many collateral managers built par, with other benchmark improvements against rating actions and price movements. With CLO reinvestment periods typically lasting four to five years, one year's performance does not make a CLO better than another, and each manger works with different arbitrage, time frames, and equity returns. In our view, 2022 gave collateral managers some more tools to flex their muscles as we came out of the pandemic to bring par back to CLOs. At the same time, flexing these muscles for too much or too long could raise concerns that the CLOs will keep reinvesting for longer, increasing the time before the notes start deleveraging.

Table 1

In table 1, a change in the average 'CCC' category to 4% from 3% would be an increase of 100 bps, and a WAS increase to 2.65 from 2.50 would be an increase of 15 bps. To compare benchmarks, we used trustee reports from January 2022 and December 2022, with ratings, prices, and dates taken from the end of January 2022 and December 2022. The portfolio (including cash) market value is the value of the portfolio assets based on the mid-price, plus or minus--as the case may be--the amounts standing on the principal account. The portfolio traded market value is the value of the portfolio assets only based on the mid-price.

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 2022: Sector Averages Of Reinvesting European CLO Assets," published on Jan. 26, 2023.

Appendix

In this report, we included all S&P Global Ratings rated European CLOs issued before 2022 where a trustee report has been provided for each month during 2022, including only those in their reinvestment period for the whole of 2022, for a total of 195 European CLOs.

Calculation of ACB and ACPB

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.

The ACB comprises the aggregate principal balance of all collateral debt obligations plus cash proceeds in any account that represents principal proceeds, which in some cases may be a negative 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 ACB is expected to meet or exceed the target par amount. From there, the collateral manager generally will consider the ACB in managing the CLO. An ACB below target par would typically reflect a par loss in the underlying CLO portfolio during the reinvestment period.

The calculation of the ACPB--which effectively represents the numerator of a CLO's par-based overcollateralization (O/C) test--comprises the assets' collateral principal balance plus cash proceeds in any account that represents principal proceeds. From there, it starts to incorporate haircuts to the balance of riskier assets--for example, those applied for excess 'CCC'-rated assets above 7.5%, workout loans, defaulted, discount, deferring, long dated, and zero-coupon obligations. Overall, then, the ACPB may be considered a more conservative measure of CLO par value compared to the ACB.

CLOs do not include market-value triggers. Instead, they include par-based O/C tests, which haircut the par balance of riskier assets to reduce par erosion for CLO debt holders. The only instance that CLO O/C triggers become more market-value like is when a CLO holds a significant proportion of 'CCC'-rated assets, which are carried above their pre-determined excess levels, as these assets will typically be carried at market value on O/C test calculations. The O/C test calculation is ACPB divided by the rated notes' outstanding balance.

Collateral managers use the ACPB as the numerator in O/C tests, and we commonly use the same value in our cash flow analysis to assess the excess spread available to a transaction.

In our analysis, we consider the target par as an important threshold. When the ACB is above a CLO's target par, a series of par leakage actions can take place while the ACB still remains above it--for example, excess ramp-up leakage early in the life of the transaction, excess principal following a refinancing, trading gains, and to purchase workout loans.

CLO reinvestment criteria

Under CLO reinvestment criteria, during the reinvestment period, the asset price is generally not a factor by itself. This enables collateral managers to trade and build par for the CLO by selling an asset, which the CLO holds at par, and substituting it with one with a lower purchase price than the sale proceeds received. In this way, the par amount from the new asset exceeds the par amount of the old asset for the same given cash amount. A CLO can also free up cash by buying less of the new obligation, at the lower price, than the proceeds received--thereby matching the par amount of the two assets and keeping the remaining cash in the principal account for future investment--as long as it meets other requirements, including:

• Coverage tests, portfolio profile tests, and the collateral quality tests are satisfied, maintained, or improved (except in circumstances where default proceeds are reinvested in which case coverage tests are satisfied).
• The par amount of substitute assets, purchased with proceeds received from the sale of credit-impaired or defaulted assets, must be equal to the sale proceeds received from the credit-impaired or defaulted assets to avoid further par loss in the trade.
• The par amount of substitute assets, purchased with proceeds received from the sale of credit-improved or discretionary sales must maintain par unless the transaction is currently above par, in which case, the target par must at least be maintained.

There are also other factors to consider with reinvesting. Market volatility in the secondary markets does not give the collateral manager a free ride to invest in unlimited under-valued-priced assets.

There are haircuts to coverage tests for assets classified as "discount obligations" where the purchase price is below 80 for loans and 75 for bonds (and for some transactions, the lower of the purchase price and an eligible loan/bond index). The discount obligations would no longer be classified as such if it traded typically above 90 (at a price set as per the CLOs documentation) for a set period of time. A collateral manager could buy these discount obligations with a haircut in the ACBP and expect the price to rise and reach market value as the secondary markets stabilize, classifying the asset as a non-discount obligation and achieving par value credit.

Collateral managers may also release any trading gains to interest and flush to equity noteholders, but only when the CLO ACB remains above target par, which is an incentive to maintain or increase par. Market value gains can be:

• Treated as a trading gain for interest leakage;
• Reinvested with an increased par amount;
• Reinvested with the same par amount with the remaining market value gain being placed in the principal account; or
• Used to purchase above par for a credit quality asset to improve other benchmarks.

Another tool to build par for the collateral managers is to go into the red in the principal account (often referred to as the negative trade date cash balance) to purchase assets. Collateral managers using this approach could also buy assets below a price of 100 at the expense of having an overdraft and typically have an aggregate principal balance of all collateral debt obligations minus the negative amount on the principal account being above target par.

Related Criteria And Research

• Weekly European CLO Update, May 15, 2023
• CLO Pulse Q3 2022: Sector Averages Of Reinvesting European CLO Assets, Jan. 26, 2023
• ESG Credit Indicator Report Card: Global CLOs, Nov. 24, 2022
• European CLOs: Is The Loan Maturity Wall CLOsing In?, Sept. 1, 2022
• European Leveraged Finance Q2 2022: It's Not The Fall That Kills You, Aug. 8, 2022
• European Corporate Credit Outlook Midyear 2022: Lights Dimming, July 28, 2022
• Credit Conditions Europe Q3 2022: Pain On The Horizon, June 28, 2022
• How Is European CLO Documentation Evolving To Address ESG Considerations?, June 9, 2022
• The Influence Of Corporate ESG Factors In Our Credit Rating Analysis Of European CLOs, April 20, 2022
• The European CLO Market: Where's The Par?, March 14, 2022
• ESG Industry Report Card: Collateralized Loan Obligations, March 31, 2021
• All You Need To Know About CDO Monitor, March 26, 2020
• Leveraged Finance: A 10-Year Lookback At Actual Recoveries And Recovery Ratings, Feb. 4, 2019
• European Structured Finance Scenario And Sensitivity Analysis 2016: The Effects Of The Top Five Macroeconomic Factors, Dec. 16, 2016
• Global Structured Finance Scenario And Sensitivity Analysis 2016: The Effects Of The Top Five Macroeconomic Factors, Dec. 16, 2016