Downgrades to leveraged loans are potentially the biggest difficulty for European CLOs at present, most notably downgrades to triple-C, while the prospect of rising defaults is also a growing concern.
“Downgrade risk is the biggest concern for us,” comments a CLO manager. “Specifically downgrades to triple-C, as those are what really hurt you. We think downgrades will hurt a lot sooner than a rise in defaults will, and I imagine we are all focused on this with our current portfolios.”
S&P Global Ratings is mindful of this situation, with the agency today releasing a report titled ‘European CLOs: Assessing The Credit Effects Of COVID-19’. In the report, S&P comments: “In the short term, we do not expect rated European CLO transactions to experience significant downgrades. Key transaction indicators such as the level of 'CCC' category rated assets, the proportion of defaulted assets, and overcollateralization cushions, suggest transactions are protected from a degree of deterioration in portfolio credit quality. However, an extended period of stress may put downward pressure on our CLO ratings, initially affecting speculative-grade tranches.”
S&P has so far taken negative rating actions on “208 U.S. and EMEA speculative-grade corporate issuers, to which European CLOs are exposed, for reasons related to the spread of COVID-19, including downgrades, and negative outlook and CreditWatch placements”. But the good news here is that while (on aggregate) these credits are included in the portfolios of 110 European CLOs that S&P rates, they account for only 7% of the total portfolio exposure by notional amount, the agency says.
So far, the companies to have been pushed into the triple-C category are (along with how many CLOs hold them, according to S&P): Hurtigruten (45), Codere (18), and Travelex (2). Those firms that have been pushed to B- territory are Vue (72), Cassini (40), Comet (7), and Amphora (6).
Many of the industries CLOs have the highest exposure to are, for now, those that look likely to be less impacted by the coronavirus crisis (though clearly there will still be a negative impact), namely software (9.29% exposure), healthcare (9.13%), and telcos (5.02%) — and these are three of the four main industries to which CLOs are exposed. Chemicals (8.68%) is the other sector in the top-four, and is classified medium risk by S&P.
Another reason for CLOs to remain constructive is that they “benefit from structural features such as excess spread, tranching, and the deferability of coupon payments on the mezzanine and junior notes,” S&P comments. The agency says this makes CLO structures relatively resilient, and that “an increase in corporate downgrades is unlikely to lead to any CLO tranche defaults in the short term. A more likely scenario is that speculative-grade CLO tranches (and possibly some tranches originally rated 'BBB') could be downgraded.”
That’s the good news, but there are reasons to be concerned too. Should a CLO breach its triple-C limit, this could lead to funds being diverted to repay the senior notes — thereby increasing the CLO's average cost of debt and reducing excess spread. Moreover, S&P expects that “increases in 'CCC' category rated assets and defaults in the underlying portfolio will lead to a downgrade of the tranches, mainly at the bottom of the CLO capital structure. Even senior tranches, structured with limited cushion, may also see negative rating actions.”
In the current environment, it is hard to see both downgrades to triple-C and defaults picking up, and multiple-notch downgrades are likely, meaning there is a far bigger universe of potential triple-C credits than first meets the eye.
S&P’s view — which is echoed in the thoughts of numerous market sources — is that a surge in the European speculative-grade corporate default rate to the high-single-digits is expected over the next 12 months, although the severity will “vary significantly by sector and individual credit characteristics”.
Meanwhile, David Riley, CIO at BlueBay, yesterday wrote: “Our estimates suggest that credit spreads imply annual default rates of around 13% and 11% for US (ex-energy) and euro high yield bonds — broadly comparable to the peak annual default rates in the global financial crisis”.
This is because most people now think a global recession is unavoidable, while the closing of capital markets will mean companies can’t as easily raise financing, and a liquidity crunch will ensue. For now, companies are widely drawing on the revolvers and there have been huge amounts of government support pledged, but cash flow generation is going to be severely hampered and it is impossible to see how this does not lead to more downgrades and defaults.
Furthermore, companies rated 'B-' and below will likely suffer most from financing needs and rapid rating transitions, according to S&P: “These companies are most likely to lack the financial flexibility to weather a crisis hitting both their top-line revenue and financing costs. They are also the most exposed to risks of distressed exchange or debt restructuring, which would qualify as a default under our ratings definitions”.
Still, the impact of all this will differ from credit to credit, and CLO managers will now prove their expertise by how they can navigate through the current situation, and rotate collateral pools to dodge the blow-ups. For that though, a liquid and functioning secondary space is needed, and the market is still some way off seeing that return.
CLO managers remain constructive however, adding they are not forced sellers of assets, and as such are in a far stronger position than most other credit funds at present, with some players noting they are still able to add to or reduce single names, even if rotating credits remains difficult due to ongoing wide bid/offer spreads.
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