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COMMENTS

CLO Portfolio Overlap: European Managers May Look Beyond Their First Choice Of Assets In The COVID-19 Era

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CLO Insights: More Than 10% Of U.S. CLO Ratings Lowered In Q3; Stabilized O/C Ratios Expected To Slowly Improve Heading Into October

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Servicer Evaluation: TaxServ LLC

Take Notes: 2020 European Structured Finance Conference Recap: Where Do We Go From Here


CLO Portfolio Overlap: European Managers May Look Beyond Their First Choice Of Assets In The COVID-19 Era

Chart 1

image

This year, COVID-19 has notched up the difficulty level of managing European collateralized loan obligation (CLO) portfolios even further for CLO managers. As European economies move deeper into recession, S&P Global Ratings expects that the number of speculative-grade corporate borrowers to default will increase (see "Credit And Economic Deterioration Signals A Rising European Speculative-Grade Default Rate Despite Market Optimism," published on Aug. 18, 2020). European cash flow CLOs--which invest primarily in these loans made to speculative-grade companies--hence may face strong headwinds. These conditions, combined with other factors, could reduce the loan universe into an even smaller subset for managers to choose from to build their portfolios.

Since the beginning of 2013--considered the start of the "CLO 2.0 era" in Europe--CLO managers traditionally have had fewer assets to build CLO portfolios than U.S. managers. Following the COVID-19 outbreak and with other restrictions in the CLO issue documents, European managers now have even fewer assets, and face a complex challenge of selecting creditworthy loans.

In 2009, the level of CLO transaction overlap stood at 28%, which increased to 38% by 2018, whereas manager overlap had increased to 74% from 59% from 2009 to 2019. However, 2020 has seen a reduction in the overlap percentage, with CLO manager overlap totaling about 71% and transaction overlap about 36%. Interestingly though, the transaction level overlap for CLOs issued since Mid-March this year tells a different story.

S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The consensus among health experts is that the pandemic may now be at, or near, its peak in some regions, but will remain a threat until a vaccine or effective treatment is widely available, which may not occur until the second half of 2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

How Are Managers Building Post COVID-19 CLOs?

Despite the recent challenges faced by CLO managers outlined above, CLO issuance has gained momentum since June. Year-to-date issuance has reached €13.2 billion from 40 CLOs, despite representing an overall year-on-year decline.

Structures in the current environment continue to be smaller (with approximately €300 million asset portfolios) and continue to have higher credit enhancement. These CLOs also have shorter reinvestment and non-call periods. At the same time, CLO documents continue to evolve, with managers changing their industry concentration limits to reflect the new environment. These changes would allow CLO managers to buy assets from certain industries to compensate for the worst-performing ones, such as oil and gas, or retail. Some CLO documents are now allowing the provision of more 'CCC' rated assets in the portfolios. Proposed changes to certain definitions in CLO documents, such as the discount obligation and defaulted loans, have also become more frequent.

With these developments in mind, table 1 shows that the average portfolio overlap in CLOs issued since the COVID-19 outbreak has already started to increase, compared to the averages seen in CLOs before COVID-19.

Table 1

European CLO Portfolio Overlap: CLOs Issued Since COVID-19
CLOs* Accunia IV Avoca XXI Avoca XXIV Bilbao III Carlyle 2020-1 Dryden 74 Fair Oaks II Harvest XXIII Invesco IV MAN GLG VI Penta 7 Sound Point III St. Paul's XII Voya Euro CLO III DAC
Accunia IV
Avoca XXI 37.36%
Avoca XXIV 37.88% 68.94%
Bilbao III 25.64% 28.86% 29.23%
Carlyle 2020-1 27.96% 43.56% 34.95% 24.66%
Dryden 74 28.55% 42.56% 41.35% 23.59% 34.96%
Fair Oaks II 37.25% 36.19% 37.57% 27.35% 31.57% 28.38%
Harvest XXIII 36.13% 49.25% 48.13% 31.53% 41.06% 37.53% 34.13%
Invesco IV 33.26% 43.20% 40.60% 29.22% 37.02% 35.04% 30.82% 48.18%

MAN GLG VI

31.73% 37.75% 35.08% 25.25% 30.49% 29.78% 31.08% 36.73% 32.75%
Penta 7 34.05% 44.02% 43.38% 28.98% 32.90% 36.78% 34.81% 43.51% 35.12% 39.00%
Sound Point III 36.11% 45.75% 43.01% 30.11% 34.06% 35.69% 36.59% 43.11% 36.56% 39.92% 39.50%
St. Paul's XII 38.35% 42.28% 45.04% 33.62% 32.35% 37.25% 39.05% 44.54% 40.95% 32.74% 44.85% 42.27%
Voya Euro CLO III DAC 38.33% 50.98% 50.12% 29.05% 40.46% 40.76% 40.51% 50.64% 44.04% 43.69% 46.27% 51.21% 47.16%
*Issued since COVID-19 (March 2020). Source: S&P Global Ratings.

The average overlap of European CLOs issued since mid-March stands at 37.73%, which is almost 2% higher than the European average of 36% for all CLOs rated by S&P Global Ratings, including those issued before COVID-19.

Click here to view the high resolution interactive version of the below chart.

Chart 2

Although CLOs issued since March this year have more overlap, the average credit quality of new CLO portfolios has outperformed pre-COVID-19 issued CLOs. Specifically, they have lower S&P Global Ratings' weighted-average rating factors at around 2,700 or below, typically less than 5% of assets are rated in the 'CCC' category (compared with a 7% average for pre-COVID-19 issued CLOs), and they generally have more 'B' and 'B+' rated assets in the portfolio. These factors, along with better structural protections--such as higher credit enhancement--could benefit new CLOs when considered within the overall European CLO universe.

Table 2

Selected Average Credit Metrics
B-' (%) CCC' category (%) Non performing category (%) Junior O/C cushion (%) WAP SPWARF Par change (%) CreditWatch negative (%) Negative outlook (%)
Jan. 3, 2020 18.44 3.19 0.10 4.24 98.61 2,704 0.00 1.00 20.68
Jan. 31, 2020 18.95 2.73 0.10 4.27 98.81 2,708 0.00 0.88 19.19
March 6, 2020 19.48 1.91 0.04 4.31 98.35 2,698 0.00 3.69 22.39
April 3, 2020 19.28 6.57 0.08 4.09 85.89 2,827 (0.07) 5.23 25.09
May 1, 2020 23.74 9.39 0.10 3.59 86.44 2,926 (0.13) 6.74 35.26
May 8, 2020 24.59 8.68 0.09 3.53 87.09 2,922 (0.15) 6.02 36.88
May 15, 2020 24.88 8.56 0.11 3.42 88.12 2,920 (0.15) 6.42 37.05
May 22, 2020 24.69 8.75 0.17 3.35 88.39 2,926 (0.16) 6.51 38.55
May 29, 2020 25.09 8.91 0.22 3.35 88.32 2,923 (0.16) 6.76 38.93
June 5, 2020 25.52 8.90 0.23 3.35 88.32 2,929 (0.16) 7.52 38.89
June 12, 2020 25.52 8.90 0.23 3.50 88.32 2,929 (0.16) 7.51 39.24
June 19, 2020 25.06 9.80 0.32 3.50 90.29 2,956 (0.14) 7.79 40.27
CLO--collateralized loan obligation. O/C--Overcollateralization. SPWARF--S&P Global Ratings' weighted-average rating factor. WAP--Weighted average price. Pricing information is based on over 90% of the loans.

How Are Managers Managing Pre-COVID-19 CLOs?

Typically, CLO managers would have a list of "first choice" assets that they would prefer to build portfolios with. In the current environment, however, with increased downgrades and negative rating outlooks on the assets, it's more likely that CLO managers would switch to using the "second best" assets for their portfolios.

Our analysis supported this possibility. The average portfolio overlap between CLO 2.0 transactions managed by the same manager was about 74% last year, with a range of 18%-89%. The average has declined to 71%, with a maximum overlap of 91%.

Click here to view the high resolution interactive version of the below chart.

Chart 3

In chart 4, we compared which CLO manager managed their CLO portfolios closest to their European average overlap and how each CLO manager compares against the European average.

Chart 4

image

Overlap Of Top 100 Names At The Lowest Levels

In our 2018 CLO overlap publication, we observed that more CLOs were now referencing assets beyond the most common names (the top 100), mainly to address widening CLO liabilities and to manage the weighted-average cost of debt (see "Portfolio Overlap In European CLOs: Looking Beyond The Top Obligors"). In 2019, the overlap of the top 100 names declined further possibly due to deteriorating credit quality and negative industry outlook during the COVID-19 pandemic (see "European CLOs: Lack Of Loan Supply Is Causing Further Portfolio Overlap"). We believe this trend will continue throughout 2020.

Efforts To Improve Portfolio Credit Quality May Reduce Overlap

Another reason for the reduced degree of portfolio overlap in existing CLOs (overlap is increasing for new CLOs issued since March 2020) could be the credit quality of existing assets in the portfolio, that has deteriorated due to the credit impact of COVID-19.

From March 13 to June 30, we took rating actions on 146 nonfinancial corporations that are referenced in CLO portfolios. Rating actions on 131 of these would have affected the credit quality of the portfolio when using our credit model, CDO Evaluator (see "COVID-19-Related Public Rating Actions On Nonfinancial Corporations And Affected European CLOs," published on June 30, 2020, and "Global Methodology And Assumptions For CLOs And Corporate CDOs," published on June 21, 2019).

Out of roughly 660 unique names referenced in S&P Global Ratings-rated European CLOs as of mid-June, if 141 were to impair the credit quality of the portfolio (translating to more than 20% of the CLO universe), this would mean that managers would likely need to trade out of such assets to avoid pressure on various CLO tests (portfolio limit, collateral quality, and coverage tests).

Cash Gains Will Add Future Buffers

Although negative rating actions on corporates had increased significantly since March to mid-June, not every industry was hit equally as hard. Managers offsetted some of the par losses due to downgrades in the most affected industries--like retail or oil and gas--by buying cheaper but fundamentally stronger credits in alternative sectors that didn't suffer as much or had more growth potential.

This caused these CLOs to gain par and cover their losses. Our sector average publication highlights that the market prices of assets in the second quarter rebounded (see "CLO Pulse Q1 2020: Sector Averages Of Reinvesting European CLO Assets," published on June 23, 2020).

These factors combined--including cashing in gains to cover losses, building portfolios to manage credit quality, and managing the weighted-average cost of debt--may have also caused a decline in overlap than in previous years.

Chart 5

image

Has Less Overlap Changed The Credit Risk Profile Of European CLOs?

Although the overlap ratio has reduced since 2018 and 2019, it hasn't yet translated into a big shift in the credit risk profile of European CLOs that we rate. We believe this is because managers' focus has been to move away from risky assets or assets from some of the riskier industries.

The European average portfolio default rate or scenario default rates (SDRs; our view of the level of defaults that is likely to affect the portfolio in a 'AAA' scenario) stood at 64.62% in mid-June (at the 'AAA' rating level). The dark blue area in chart 6 shows the deviation of our SDRs or the expected portfolio default rate in a 'AAA' scenario for each CLO managed by the same manager versus the European average, which is the straight line, symbolizing no substantial difference for the time being.

Chart 6

image

Asset Overlap For 'CCC' Ratings, CreditWatch Negative Placements, And Outlooks

Chart 7 shows the manager overlap of assets currently rated in the 'CCC' category ('CCC+', 'CCC', and 'CCC-') and those placed on CreditWatch with negative implications, or both.

Chart 7

image

Chart 8

image

On average, European CLO portfolios comprised about 7% of assets that were rated in the 'CCC' category in August ranging between 3% to 14%. The average overlap of these 'CCC' rated assets in CLO portfolios managed by the same manager accounted for 62%, meaning any further negative rating migration on such assets will likely similarly affect other CLOs from the manager. Although the overlap may be high, the proportion of assets in the 'CCC' category has gradually reduced (now accounting for about 7%) after reaching its peak in May and June.

Assets rated with a negative outlook also lead to a similar conclusion. Chart 9 shows that, on average, the asset overlap of those assets with a negative outlook accounted for 34%, ranging between 52% at the higher end to 20% overlap at the lower end.

Chart 9

image

Industry Exposure Still Diverse, Though Favorites Might Change

CLO exposure by industry exposure has changed this year. Software and chemicals continue to be the most favored industries. In line with last year, CLO managers continue to avoid exposure to high-street retail and oil/gas and aerospace industries, which Europe has traditionally shied away from investing in.

Chart 10

image

Defaults In Europe Remain Close To Zero

The 2020 global corporate default tally has reached 159 (see "Corporate Defaults In Europe Hit An All-Time High," published on Aug. 20, 2020). Defaults in Europe have surpassed their 2009 financial crisis levels and reached a historical high of 23 defaults. While this is the highest year-to-date default total over the past decade, the exposure of defaulted assets in European CLOs continue to remain well below 1%.

By actively trading, European CLO managers consistently helped CLOs avoid these names. As a result, they have maintained healthy overcollateralization and interest coverage cushions (see "European CLO Performance Index Report Q1 2020," published on June 30, 2020").

How Does Portfolio Overlap Differ From Obligor Concentration?

Portfolio overlap is the extent that an obligor can be found in several CLO transactions, while the degree of concentration measures the percentage an obligor accounts for in a given portfolio. A high level of portfolio overlap could mean that the effects of corporate defaults and credit deterioration would be more widespread across the European CLO sector, whereas the concentration affects the severity of changes in obligor credit quality on individual transactions. The combination of both characteristics contributes to higher risk, in our view.

If a widely held obligor's creditworthiness deteriorates, or if that obligor defaults, this could have ramifications on European CLO portfolios more broadly. For example, the default of the most widely held obligor could have a negative effect on the portfolio credit quality on nearly 95% of European CLOs. However, the magnitude of any effect on CLO ratings would be partially mitigated because most transactions' underlying portfolios have only a small exposure to any single corporate obligor; transaction documentation typically sets obligor concentration limits. In our sample, the average exposure to any single obligor is less than 1%.

The extent of any effect on CLO ratings will, in our view, be influenced by their portfolio characteristics, notably the overlap between different portfolios and concentration risk within them. We believe relatively high overlap in a sector means deterioration among a few key corporate obligors could affect a large number of CLOs. However, in this scenario, we generally expect that the severity of any rating effect will likely be mitigated because individual obligor exposures are typically only held in low concentrations.

Our analysis represents a snapshot of European CLO portfolio compositions for our sample as reported at the beginning of August 2020. It is not intended to capture any more recent or potential future trading activities by CLO managers. In addition, this analysis is not intended to predict the future performance of any individual CLO, as each transaction has unique portfolio characteristics.

Appendix: Calculation Of Overlap Between Two CLO Portfolios

We calculate the degree of overlap between two CLO portfolios by first establishing the concentration of each obligor in each portfolio. For example, consider two portfolios:

  • Portfolio A contains obligors X and Y, which constitute 1.0% and 2.0% of the portfolio, respectively, and
  • Portfolio B also contains obligors X and Y, which constitute 3.0% and 1.5% of the portfolio, respectively.

For each obligor, the contribution to the overall overlap is the lower of the concentration in the first portfolio and that in the second portfolio.

In our example:

  • Contribution of obligor X to overall overlap = minimum of 1.0% and 3.0% = 1.0%, and,
  • Contribution of obligor Y to overall overlap = minimum of 2.0% and 1.5% = 1.5%.

Assuming all other obligors only appear in one portfolio, but not the other, then the total overlap will be the sum of the contributions from obligors X and Y, i.e., 1.0% + 1.5% = 2.5%.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst: Abhijit A Pawar, London (44) 20-7176-3774;
abhijit.pawar@spglobal.com
Secondary Contact: Emanuele Tamburrano, London (44) 20-7176-3825;
emanuele.tamburrano@spglobal.com
Research Contributor: Shubham Verma, CRISIL Global Analytical Center, an S&P Global Ratings affiliate, Mumbai

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