Rising interest rates and slowing growth challenged loan issuers in 2023, and downgrades have outnumbered upgrades among U.S. broadly syndicated loan (BSL) collateralized loan obligation (CLO) obligors every month in 2023. This continues a 20-month streak that began in May 2022. A significant number of loan issuers saw their ratings lowered to 'B-' and lower this year. Many of these downgrades were concentrated in the consumer discretionary sector and healthcare-related sectors, both of which had similar number of downgrades into the 'CCC' range and below during the year, although more healthcare-related issuers were downgraded to 'B-'. At the GICS sector level, industrial and information technology related companies account for the largest dollar exposures across CLOs, but were only the fourth- and third-largest, respectively, by count of downgrades last year.

Table 1

Year-end exposure to 'CCC' and nonperforming assets in U.S. BSL CLO portfolios increased to a three-year, post-pandemic high in 2023. However, despite the high count of companies with ratings lowered to 'B-' in 2023, after peaking in April 2023, exposure to 'B-' assets in U.S. BSL CLO collateral pools declined for the first time in seven years, ending the year at levels last seen around late 2021. This partly reflects what's happening with corporate loans more broadly as 'B-' issuers find it more difficult to issue into the BSL loan market. It's also the result of CLO managers de-risking their portfolios and, in some cases, investing in bonds from higher-rated (although still speculative-grade) companies. By year end, BSL CLO exposure to assets from investment-grade, 'BB' category', and 'B+' companies had experienced a modest uptick. For more on de-risking of CLO portfolios by managers see "Managers Matter: Active Management Of U.S. BSL CLOs During Uncertain Times Shows Its Value," published Nov. 30, 2023, where we find managers replace assets weaker credits with better credits, often at a loss in par, in 2022 and 2023.

Chart 1

During the year, across rated reinvesting U.S. BSL CLO portfolios:

• 'CCC' buckets increased by 3.0%, to 7.7% from 4.7%;
• Junior overcollateralization (O/C) cushions declined by 0.9%, to 4.08% from 4.95%; and
• Par balance of portfolios declined by 0.4%, to 99.76% from 100.16%.

As noted in the table above, 'B-' exposures declined notably in 2023, while exposure to assets from companies rated 'B+' and higher rose slightly. This resulted in the S&P Global Ratings' weighted average rating factor (SPWARF) of the index ending the year at the same level as the start. The average BSL CLO portfolio still ends the year with higher exposures to companies with a negative rating bias (that is, with ratings either on CreditWatch negative or with a negative outlook). We find the ratings bias to be a good forward-looking indicator of where corporate ratings might be headed.

Table 2

Managers Matter, But So Does Vintage

When we create cohorts across our index of reinvesting transactions by transactions that originally closed before and after the pandemic, we see notable differences in the metrics. Transactions that closed before the pandemic have less exposure to assets from 'B-' companies, greater exposure to assets from 'CCC+' and below-rated companies, lower junior O/C test cushions ,and lower par balances relative to their target par level.

Table 3

Many of these pre-pandemic transactions will exit their reinvestment periods in 2024. Reset activity was relatively muted in 2022 and 2023, resulting in a historically larger proportion of transactions outside their reinvestment period. As of the start of 2024, 30.8% of rated U.S. BSL CLO transactions are outside their reinvestment period. By the start of 2025, that proportion could increase to 43.2% given current deal counts, though this proportion will likely be lower by the end of 2024 due to new issuance counts, potential reset activity, and deals going away through optional redemptions during the year.

In July 2022, we published an article regarding 11 CLO 2.0 'BB' tranches that had defaulted, and looked for factors they all had in common (see "The Dirty (Almost) Dozen: What Separates Defaulting U.S. CLO 2.0 Tranches From The Rest," published July 7, 2022). We found that all the CLO 2.0 transactions with defaulting tranches had at least two things in common: they'd been though two economic downturns (the oil, gas, and commodities downturn in 2015-2016 and then the pandemic in 2020), and all of them were outside the end of their reinvestment period, or close to it, when the second downturn arrived.

More recently, we've observed a few seasoned CLO transactions that have been amortizing for some time that have an unclear road to optional redemption because the current market values of the residual assets are not sufficient to cover the rated liabilities. Unless market values of the weaker loans in these collateral pools pull to par and increase to a level that makes redemption feasible, some of the subordinate notes from these CLOs could be on a glide path to a default scenario (which would likely be several years out given the CLO maturity dates). We currently have 36 junior (original 'BB' or lower rated) CLO tranches that fit this description, rated within the 'CCC (sf)' rating category. While it's unlikely that all of these would default, the 'CCC (sf)' category current ratings assigned reflect our view that some of them could.

Anytime the topic of CLO tranche defaults comes up, it's worth reminding ourselves of the strong performance the asset class has shown historically. S&P Global Ratings rated its first CLO 30 years ago, and since then, we have rated about 18,000 U.S. CLO tranches. Of these, just 59 have defaulted (see "U.S. CLO Tranche Defaults As Of July 27, 2023," published Aug. 2, 2023). That reminder seems like a good way to start 2024.