European CLOs suffer in COVID-19 era

The impact of COVID-19 on the European leveraged loan market fed through to collateralized loan obligations, with defaults up and loan supply down.

A report by S&P Global Ratings said the CLO market was "hit hard by the pandemic." Defaults and CCC-rated asset holdings were up, loan supply fell and CLO managers that chose to trade out of weaker corporate sectors in some cases have experienced par losses, the report said.

"All combined, these factors have negatively affected European CLO ratings, largely in the form of CreditWatch negative placements and downgrades of junior tranches," it said. The ratings agency uses CreditWatch and rating outlooks to show its view on how likely a ratings change is and the probable direction of such a change.

Since March, S&P has put 39 European CLO ratings on CreditWatch negative, with about two-thirds of those actions subsequently resoled with a downgrade. The average downgrade was one ratings notch. As of Dec. 1, no European CLO ratings were on CreditWatch negative.

Pressure on European CLO ratings was predominantly seen in junior parts of the capital structure, at the BB and B-rating levels.

S&P's report also noted that moves by managers away from affected names and potential losses — along with "structural mitigants embedded in CLOs — explain why our rating actions on junior CLO tranches have been limited so far. On average, the magnitude of rating changes has been one notch, and to date we have not lowered any investment-grade ratings to speculative-grade."

The report said the wave of COVID-19-related rating actions on non-financial corporations began around April. By May, the 12-month trailing European speculative-grade default rate had increased to 2.7% from 2.3% a month earlier. At the same time, CCC-rated buckets in European CLO portfolios began to breach their limits in an increasing number of transactions, it said. Limits are typically set at 7.5%.

What followed was downward pressure on ratings and the difference between the tranche break-even default rate and its scenario default rate — the rating cushion — began to erode, the report said, resulting in the first and largest set of CreditWatch negative placements on European CLO ratings to date.

Since peaking in the second quarter, the rate of negative corporate rating actions has abated, along with pressure on CLOs and rating actions, the report said.