Nineteen new European CLO transactions priced in the fourth-quarter of 2019, taking total 2019 issuance volume to a record €29.82 billion from 72 transactions and exceeding the €26.31 billion from 66 transactions in 2018. Total issuance to date stands at €5.83 billion across 14 CLO transactions, just slightly below the €6.03 billion from the same number of transactions over the same period last year.

In this quarterly index publication, we look at some of the key metrics behind our ratings on the CLO notes. A month-to-month negative performance of these parameters could pressure the ratings on the notes.

Challenging Arbitrage Conditions Persist With Widening Liability Spreads

Following a widening of CLO spreads toward the end of 2019, increasing demand for CLO paper led to spread tightening across the capital stack, with the 'AAA' spread on Avoca CLO XXI DAC achieving a new low of 89 basis points (bps) and the weighted-average cost of capital reaching 1.6% at the end of February 2020. While this tightening of CLO liabilities helped improve arbitrage conditions--which have been facing additional pressure from the recent wave of repricings on the underlying asset--the respite proved temporary. Increasing market concerns over the spread of COVID-19 led to a widening of CLO liability spreads, with Madison Park Euro Funding XV DAC pricing last week at 120 bps with a weighted-average cost of capital at 2.3%. Amid already decreasing equity returns, CLO issuers incorporated in the Netherlands also face an additional challenge with the removal of Dutch VAT exemption on management fees, which will further reduce distributions to equity noteholders.

'CCC' Rating Category Exposure Is Increasing, Although It Remains Low

Fundamental concerns about underlying assets' credit quality persist, particularly in relation to the potential rating migration of 'B-' rated issuers to the 'CCC' rating category (see "European CLO Performance: An Interactive Look At Exposure To 'B-' Rated Assets," available at https:// www.spglobal.com/en/research-insights/articles/european-clo-performance-an-interactive-look-at-exposure-to-b-rated-assets). In fourth-quarter 2019, exposure to assets rated in the 'CCC' rating category increased quarter-on-quarter, driven in part by the downgrade of five public corporate issuers to the 'CCC' rating category from 'B-' (see "Appendix 1").

Chart 1

European CLO exposure to 'CCC' category rated assets remains low, with the average transaction having a 2.9% exposure and with more than 75% of CLOs having an exposure of 4.0% and below. All European CLO transactions except one remain below the typical 7.5% limit in transaction documentation. Exposure over this limit is carried at a haircut for the purpose of the overcollateralization (O/C) test so that it breaches quicker and, in times of stress, diverts interest to deleverage the most-senior tranche. To understand how increasing 'CCC' rating exposure affects coverage tests generally and how variations in CLO documentation can impact noteholders differently, see the video "CLOs Simplified Episode 2: How CCCs Impact Coverage Tests," available at https://www.spglobal.com/ratings/en/research-insights/videos/20200324-clo-simplified-how-cccs-impact-coverage-tests

Chart 2

A higher concentration of assets rated 'B-' and below generally implies a riskier portfolio. This is reflected in a higher S&P Global Ratings weighted-average rating factor (SPWARF), which in turn, increases the scenario default rate, our measure of portfolio credit risk. While there is generally a positive relationship between the SPWARF and the proportion of assets rated 'B-' and below, differences can occur due to the barbelling of portfolios.

As a result of market participant requests, we have also included a list of public issuers rated 'B-' and in the 'CCC' rating category in Appendix 2.

COVID-19 Is A Key Challenge

COVID-19 will be one of the key challenges faced by the European leveraged loan and CLO market in 2020. The effect will vary depending on the length and the severity of the outbreak. What has become clear in the last few weeks is that it is no longer just an issue for China and its economic partners. We now expect a contraction in Eurozone GDP growth of 0.5%-1.0% in 2020, revised down from our previous forecast of 0.5% growth (see "COVID-19 Macroeconomic Update: The Global Recession Is Here And Now," published on March 17, 2020).

In our view, we believe measures to contain COVID-19 have pushed the global economy into recession. The collapse in oil prices and extreme volatility in capital markets will have severe implications for credit markets and likely mean a surge in defaults, with the default rate of nonfinancial corporates in Europe rising into the high single digits over the next 12 months (see "COVID-19 Credit Update: The Sudden Economic Stop Will Bring Intense Credit Pressure," published on March 17, 2020).

Some sectors, such as those linked to travel, tourism, or leisure, or those relying on global supply chains (auto, electronics, and chemicals) could see increased pressure on revenue and earnings (see "Global Credit Conditions: COVID-19's Darkening Shadow," published March 3, 2020). To date, our ratings on an increasing number of issuers with exposure in European CLOs have experienced a negative effect in part because of COVID-19 related concerns (for a full list of rating actions, see Appendix 1).

We expect there will be further rating actions across issuers held in European CLOs and will continue to monitor in the coming weeks.

S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak between June and August, and we are using this assumption in assessing the economic and credit implications. We believe measures to contain COVID-19 have pushed the global economy into recession and could hurt employment levels and housing markets (see our macroeconomic and credit updates here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Measuring CLO Performance Using Key Metrics

CLO issuance has gained momentum over the past five years, and investors have become more familiar with CLO structures and the associated risks, as well as assessing and suitably measuring credit and cash flow risks.

Credit risk, which includes default risk and an increase in 'CCC' category rated assets in the portfolio, among others, can be mitigated by better measures on the cash flow side, like increased available credit enhancement, weighted-average spread, and recoveries, for example.

In this article, we display how these individual parameters have evolved over the last few months to broadly gauge the performance of European CLOs.

CLO Performance Shows Slight Credit Deterioration In Fourth-Quarter 2019

Overall, CLO performance in fourth-quarter 2019 has shown slight credit deterioration compared to the previous three quarters, with an increase in 'CCC' category rated assets, and worsening of the SPWARF and scenario default rate. Most of the other metrics we capture showed stable performance.

Collateral portfolios of older vintage cohorts are becoming more concentrated as the assets wind down and they approach their final maturities, while newer vintages are benefiting from still being in their reinvestment phases, when collateral managers can actively mitigate default risk through active trading. We attribute these trends more to the stage in a transaction's life cycle than to significant changes in the portfolios at the collateral level.

Credit Metrics

European CLO 2.0 collateral ratings

While CLOs enjoy the senior secured status of leveraged loans in the portfolio, it is important to note that these loans are issued to speculative-grade companies.

Underlying collateral ratings contribute significantly to the ratings on transactions that have closed since January 2013. Below we show the rating distribution of the CLO collateral portfolio for the different vintages in European CLO 2.0 transactions over a one-year period (see charts 3 to 8). Note that we have considered transactions that have been refinanced to be in the original vintage as when it was first issued. The CLO portfolio rating performance across all CLO vintages indicates stable performance.

Chart 3

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Chart 6

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Chart 8

Exposure to 'CCC' rated assets has increased

'CCC' category rated assets are an important measure of European CLO performance because an increase in these assets can indicate that the collateral portfolio's credit quality is worsening. The level of 'CCC' assets can also reduce O/C test cushions because they may not be carried at their full par value.

The percentage of assets rated in the 'CCC' category ('CCC+', 'CCC', or 'CCC-') has shown slightly worse performance for the European CLO cohorts we track. These changes reflect rating migration in the underlying portfolios and may also depend on an individual transaction's pool composition, which is based on the CLO manager's strategy to manage the vehicle.

By vintage, the reported level of 'CCC' rated assets in European cash flow CLOs, as a percentage of total assets in November 2019, was:

• 2013 vintage CLOs: 1.80% of total assets (up from 0.82% in August 2019);
• 2014 vintage CLOs: 2.95% of total assets (up from 1.13% in August 2019);
• 2015 vintage CLOs: 3.35% of total assets (up from 1.61% in August 2019);
• 2016 vintage CLOs: 1.88% of total assets (up from 0.84% in August 2019);
• 2017 vintage CLOs: 1.94% of total assets (up from 0.91% in August 2019); and
• 2018 vintage CLOs: 1.91% of total assets (up from 0.99% in August 2019).

Chart 9

Individual CLOs exhibited some variances among European CLOs from the same vintages. These CLOs are more likely to breach their thresholds sooner than other types of CLOs.

Exposure to defaulted assets remains limited

CLOs performed well through the financial crisis and beyond. Defaulted assets were one of the key indicators of CLO performance because a defaulted asset may result in a loss of principal to the CLO and a corresponding decline in credit enhancement.

From August 2019 to November 2019, the percentage of defaulted assets (i.e., assets from obligors rated 'CC', 'C', 'SD' [selective default], or 'D') slightly increased for the 2013, 2017, and 2018 vintages, and decreased for the 2014, 2015, and 2016 cohort.

As of November 2019, the percentage of defaulted assets in each underlying collateral portfolio was:

• 2013 vintage CLOs: 0.52% of total assets (up from 0.46% in August 2019);
• 2014 vintage CLOs: 0.00% of total assets (down from 0.15% in August 2019);
• 2015 vintage CLOs: 0.18% of total assets (down from 0.34% in August 2019);
• 2016 vintage CLOs: 0.02% of total assets (down from 0.14% in August 2019);
• 2017 vintage CLOs: 0.15% of total assets (up from 0.10% in August 2019); and
• 2018 vintage CLOs: 0.14% of total assets (up from 0.07% in August 2019).

These calculations show the proportion of assets that are currently in default, over total assets (not including principal cash).

Chart 10

S&P Global Ratings' weighted-average rating factor (SPWARF) worsens

Although CLOs are generally restricted to eligibility criteria that govern what assets can be part of their portfolios and set their limitations, it is challenging to size a portfolio's default risk during the typical four-year reinvestment period in which the collateral manager is allowed to actively trade assets. These trading activities could change the asset portfolio's composition significantly, thus increasing its risk profile and possibly the required par subordination.

The SPWARF provides an indication of the portfolio's overall credit quality. It is each asset's five-year default rate assumed in our corporate collateralized debt obligation (CDO) criteria, weighted by each asset's par balance, and multiplied by 10,000 (see the "Related Criteria" and "Related Research" sections).

In fourth-quarter 2019, the overall SPWARF increased to 2,650 from 2,612.

Chart 11

Weighted-average life (WAL) decreased

The WAL is the number of years between the current date and the maturity date of assets in the CLO portfolio.

At 5.1, the WAL is decreasing quarter on quarter.

Chart 12

Scenario default rates (SDRs) worsen

Together with the SPWARF and WAL, we use four other benchmarks (the three diversity measures and the default rate dispersion [DRD]) to produce the approximate 'AAA' SDR (i.e., the expected default levels for the portfolio under the 'AAA' stress scenarios).

While the SPWARF only looks at the credit rating on the assets, SDRs (or the expected target default rate) look into all six components when measuring the overall risk profile of a CLO portfolio (SPWARF + DRD + WAL + the three diversity measures).

On average, the current portfolio credit risk ('AAA' SDRs) has slightly worsened in comparison with third-quarter 2019, increasing to 61.44% from 61.22%.

Chart 13

Cash Flow Metrics

Credit enhancement has remained steady

Our analysis of CDO transactions, as in our other structured finance ratings, focuses on how much credit enhancement is needed for a given level of credit risk to achieve a specific rating. Typically, credit enhancement is provided by a combination of overcollateralization/subordination and cash collateral. In this case, credit enhancement is the percentage of total performing assets plus cash, minus the tranche balance (including senior and pari passu note balance), divided by total performing assets, plus cash plus recovery on defaulted assets. The credit enhancement levels across the capital structure remained stable over 2019.

Table 1

Weighted-average spread followed recent quarterly trends

Spreads vary based on a variety of factors, including the levels of relative liquidity for leveraged loans or the actual and perceived level of credit risk in the leveraged loan market, among others.

Over the past two to three years, leveraged loans have refinanced at a lower cost, leading to increased difficulty in managing the weighted-average spread test in CLOs and in maintaining the weighted-average cost of debt and a healthy return to equity. Consequently, weighted-average spreads are monitored closely in CLOs. If this measure decreases significantly, the risk of a negative rating action on the notes would increase.

On average, the weighted-average spread has remained stable over the past three quarters, which has helped CLO managers manage their weighted-average spread tests.

Chart 14

Senior O/C ratios showed some improvement

The senior O/C ratio test is a par value test to protect senior noteholders. Declines in the senior O/C ratio test results can indicate decreasing credit quality of the CLO. The O/C ratio is the difference between the O/C test calculated for a particular tranche and the trigger associated with it. Breach of these triggers will mean that senior notes are repaid (until the tests are met again), or if the transaction is in its reinvestment period, the proceeds due on junior notes are either invested in substitute collateral or used to repay the notes.

The senior O/C ratio test cushions improved from August 2019 to November 2019 for all the cohorts except 2013 and 2018 (see chart 15).

The senior O/C ratio test cushions (based on reported information) as of November 2019 were:

• 2013 vintage CLOs: 9.12% (down from 9.25% in August 2019);
• 2014 vintage CLOs: 13.44% (up from 10.70% in August 2019);
• 2015 vintage CLOs: 10.74% (up from 9.13% in August 2019);
• 2016 vintage CLOs: 9.88% (up from 9.87% in August 2019);
• 2017 vintage CLOs: 9.71% (up from 9.61% in August 2019); and
• 2018 vintage CLOs: 9.54% (down from 9.57% in August 2019).

Chart 15

Subordinated O/C ratios dipped slightly

The subordinated O/C ratio test is the par value test for the junior notes in the CLO. Failure to satisfy this test will typically cause interest and principal to be redirected to pay down the most-senior class of notes until the test is satisfied.

From August 2019 to November 2019, the subordinated O/C ratios showed slightly worsened performance for all of the CLO 2.0 vintages we track except 2015 (see chart 16).

As of November 2019, the subordinated O/C ratio test cushions (based on reported information) were:

• 2013 vintage CLOs: 3.76% (down from 3.85% in August 2019);
• 2014 vintage CLOs: 3.77% (down from 3.80% in August 2019);
• 2015 vintage CLOs: 3.88% (up from 3.86% in August 2019);
• 2016 vintage CLOs: 4.60% (down from 4.65% in August 2019);
• 2017 vintage CLOs: 4.23% (down from 4.28% in August 2019); and
• 2018 vintage CLOs: 4.31% (down from 4.40% in August 2019).

Chart 16

Notes

Our European CLO performance index report provides aggregate performance statistics across most of our rated European cash flow CLO transactions backed primarily by corporate loans. We provide this information to help market participants track the overall performance of European cash flow CLO transactions and to benchmark the performance of the transactions they follow against the performance of cohorts of similar transactions.

Our report highlights what we view as a number of key risk areas for the transactions, and which we use as part of our analysis of the credit quality of securitized portfolios and of the transactions' payment structure and cash flow mechanics. These include rating migration within the underlying collateral portfolios, as well as other information relevant to the sector.

We divide the performance information in the CLO indexes into cohorts, each containing data for most of the European CLO transactions we rated and issued in a specific vintage year. We collect the performance information from transaction-level performance data in our CDO surveillance databases.

Information prior to the most recent 12 months is available on CDO Interface, S&P Global Ratings' web-based portal for CDO performance information, at www.cdointerface.com. To generate, view, and download data from the CDO indexes, log onto CDO Interface, and then select the "Indexes" tab.

Appendix

Appendix 1

Appendix 2

Related Criteria

• Global Methodology And Assumptions For CLOs And Corporate CDOs, June 21, 2019

Related Research

• COVID-19 Credit Update: The Sudden Economic Stop Will Bring Intense Credit Pressure, March 17, 2020
• COVID-19 Macroeconomic Update: The Global Recession Is Here And Now, March 17, 2020
• Global Credit Conditions: COVID-19's Darkening Shadow, March 3, 2020
• CLO Spotlight: Fourth-Quarter 2019 CDO Monitor Benchmarks Reveal Relative Credit Quality And Diversity Of CLO Portfolios, Jan. 24, 2020
• The European Speculative-Grade Corporate Default Rate Is Expected To Reach 2.3% By September 2020, Dec. 6, 2019
• Credit FAQ: Understanding S&P Global Ratings' Updated CLO And Corporate CDO Criteria, June 26, 2019
• S&P Global Ratings' Updated Assumptions For CDO Monitor Non-Model Version, June 21, 2019
• 2018 Annual Global Leveraged Loan CLO Default And Rating Transition Study, June 19, 2019
• Glossary Of Cash Flow CLO Performance Index Fields, Jan. 30, 2009

Video available here.