(Editor's note: Charts 2, 3, and 5 are interactive, and so readers may select/deselect the data to perform their own analysis. For CapIQ or pdf viewers, to access the version of the article with the interactive charts embedded, click here).
- Of the collateral backing EMEA CLOs that we rate, €8.5 billion--or 7.8% of the total par balance--will mature by the end of 2024. A further €15.7 billion and €25.9 billion of underlying loans mature in 2025 and 2026, respectively.
- This approaching CLO maturity wall prompts closer consideration of the potential adverse effects that tighter financing conditions may have on CLO credit performance and ratings going forward.
- We ran four scenario analyses with different levels of CLO asset defaults, trading losses, downgrades, and recovery timings. Overall, CLO ratings demonstrated considerable resiliency to these additional stresses.
In the aftermath of the financial crisis, the European leveraged loan landscape was arguably transformed by fiscal stimuli, monetary loosening, and ultra-low to negative interest rates. As investors searched for yield, they moved to risk-on mode and re-balanced portfolios. This helped accommodate borrowing opportunities for leveraged loan borrowers, allowing them to tap the refinancing markets and increase senior leverage beyond the levels observed prior to the global financial crisis. That was then.
More recently, the European financial landscape has been dealt multiple setbacks, ranging from lingering supply-chain issues after the COVID-19 pandemic to the Russia-Ukraine military conflict, leading to rising energy costs, multi-decade record inflation, and rising interest rates. The resulting deterioration in market sentiment and concerns surrounding the health of the leveraged finance markets have squeezed vulnerable borrowers lacking competitive advantage and free cash flow to weather future credit and liquidity headwinds.
Tighter financing conditions are likely to persist, with benchmark rates rising alongside widening credit spreads--a stark contrast to the ultra-low funding rates corporate borrowers have historically enjoyed. This may limit refinancing opportunities for borrowers of leveraged loans backing European CLOs as they approach their scheduled maturities. Lenders in this environment may have limited risk appetite, which means that corporate borrowers face the looming risk of either refinancing onto much higher rates or otherwise defaulting on their debt payments if they are unable to secure any form of refinancing. CLO managers may of course sell these assets to mitigate their exposure, but risk incurring par losses as a result of suboptimal market prices at the time of sale.
S&P Global Ratings has taken a closer look at how upcoming loan maturities may affect European CLOs. We also explore how CLOs may be limited in aiding loan refinancing and amendment requests, due to fewer refinancing opportunities for the CLOs' own liabilities. Finally, we present stress test scenario analyses that focus on various assumptions for defaults, recoveries, and recovery timings, to determine how tough refinancing conditions may affect CLO ratings.
CLO Loan Maturity Profiles Signal Refinancing Pressures To Begin In 2023
Let's start with the underlying assets in CLO portfolios. Below, we split by rating category the aggregate amount of invested collateral in CLO portfolios scheduled to mature over the next decade. In the run up to 2024, nearly €8.5 billion of leveraged loans financed by European CLOs that we rate--representing 7.8% of the total par amount over 139 obligors--are scheduled to mature, with the bulk of maturities occurring in the second half of 2024. These corporate entities will likely explore refinancing options as early as 2023.
Most of these scheduled maturities correspond to corporate borrowers currently rated 'B-' (representing just over 40% by notional amount), which may face pressure ahead of their maturity dates. In the shorter term, CLOs are exposed to only €194.6 million of 'B-'-rated entities with maturities between now and the end of 2023, comprising term loans from just nine corporate entities spread over 81 CLO transactions.
A similar pattern follows in 2025, but with twice the par amount of assets maturing that year when compared with scheduled maturities in the run up to 2024. Once again, corporate obligors currently rated 'B-' represent most of the scheduled maturities due in 2025 (€9.33 billion), followed closely by corporate obligors rated 'B' (€8.1 billion).
Interestingly, the amortization profiles for assets in the 'CCC' category (i.e., those rated 'CCC+', 'CCC', and 'CCC-') have generally become more front-loaded and less distributed over time when compared with their profiles in 2020 (see chart 3). For instance, as of 2020, there was roughly €0.5 billion of 'CCC'-rated collateral in CLOs maturing in the following three years. In contrast, as of 2022, that amount has ballooned to over €2 billion due over the next three years. While this represents a small fraction of the overall universe spread over a greater number of CLO issuers since 2020, there is a vastly greater notional par amount of riskier assets due in the near term than compared with previous years.
In terms of individual 'CCC'-rated asset exposure in CLOs, the largest of these exposures are concentrated in four CLOs that we rate, with exposures ranging anywhere between 10.0% to 12.3% of each CLO's aggregate collateral balance. All but one of these CLOs have ended their reinvestment periods, and we focus more on this relationship in the next section.
On a forward-looking basis, this naturally brings 'CCC' haircut risks into the spotlight. In a downturn scenario CLOs may face market value haircuts in par value tests because of excess 'CCC'-category rated holdings. As chart 4 highlights, shorter-dated assets rated in the 'CCC' category generally carry lower prices than longer-dated ones, potentially pricing in refinancing risk for these assets and therefore exposing CLO par value tests to greater haircuts should these obligations form part of the excess.
Analyzing the same data set split by S&P industry classifications, leveraged loans issued by CLOs to businesses in the chemicals, diversified consumer services, hotels, restaurants & leisure, and healthcare industries represent some of the largest near-term maturities (see chart 5). These include term loans issued by common underlying names across CLO portfolio such as Archroma, Diaverum, Fugue Finance, and Entain Holdings.
Limited Refinancing Opportunities May Hinder CLOs' Capacity To Participate In Loan Refinancing Requests
Moving on to CLO liabilities, recent macroeconomic and geopolitical events have sent spreads to new highs. As a result, many (if not all) CLOs with non-call periods ending in 2022 are likely to be out of the money and therefore uneconomical for a redemption and refinancing (see "CLO Pulse Q1 2022: Sector Averages Of Reinvesting European CLO Assets," published on July 13, 2022).
Therefore, some existing CLOs may already be limited in their ability to (re)invest in loan refinancing requests, due to a combination of (1) more restrictive reinvestment criteria after a CLO's reinvestment period has ended, and/or (2) thinning weighted-average life (WAL) test cushions.
Refinance Or Resetting Allows CLOs To Extend Their WALs And Reinvestment Periods
Transactions that undergo a refinancing typically extend their WAL test when, following the end of a traditional two-year non-call period, they are likely to have little headroom against the transaction's actual WAL. In a CLO reset or reissue, structures are typically re-levered and their dates reset, meaning that the WAL test and reinvestment period are commonly extended to levels typically observed in new issue CLOs.
With regards to CLO reinvestment periods, 51 CLOs in our sample (about 20%) have already ended their reinvestment periods, with eight CLOs ending their reinvestment periods in 2023 and another 56 in 2024. Putting aside that some CLO issuers may still consider resetting their CLOs (as it may offer equity investors a relatively better return profile than remaining invested in an amortizing transaction), the issue for leveraged loan borrowers is that a CLO's reinvestment criteria following the end of its reinvestment period are more restrictive than the criteria during the reinvestment period, which potentially limits a CLO's ability to participate in loan refinancing requests. For example, during the reinvestment period, CLOs typically are required to satisfy or otherwise maintain or improve overcollateralization ratios and WAL test covenants, whereas after the reinvestment period these same covenants typically must be satisfied or improved. That said, some CLOs include "one-touch WAL" provisions, and how these are utilized depends on the performance of the WAL on the last day of the reinvestment period. As charts 6a and 6b illustrate, CLOs that have shorter or no time left in their reinvestment periods generally include a higher proportion of nearer-term maturing loans in their portfolios.
Déjà Vu: Limited Refinancing Opportunities May Result In Growing Amend-To-Extend Activity
An alternative option to the refinancing route for leveraged loan borrowers--in order to avoid a preemptive default or restructuring through a distressed exchange--is to propose a maturity amendment to their lenders. This is effectively an amend-to-extend feature, which allows borrowers to extend the maturity of their loan facilities outside of repaying any outstanding debt, and typically will include an increase in their interest payment obligations to compensate lenders. Similar amendments were a common feature in the loan market during the global financial crisis, given constrained liquidity for borrowers at the time. For CLOs, the document section(s) that outlines maturity amendments is generally titled "Amendments to the Maturity of Collateral Debt Obligations", which typically precedes the CLO's reinvestment criteria under section 6 (Management of the Portfolio) in the offering circular.
There are usually several requirements for accepting a maturity amendment, but typically include the following:
- Each borrower's extended maturity date does not exceed the CLO's maturity date. That is, the loan does not become a long-dated obligation for the CLO. This condition protects CLO investors in that it prevents or limits exposing the transaction to market-value risks; and
- The CLO's WAL test is satisfied or otherwise maintained or improved.
The conditions in these sections typically include an exemption to meeting these requirements subject to a maximum threshold (for example, 5% of the CLO portfolio balance). Furthermore, a maturity amendment may be extended to a leveraged loan borrower even though CLO lenders may have voted against the proposal, due simply to being outvoted by other lenders in the loan transaction.
Regardless of the path leveraged loan borrowers take to address near-term maturing debt, tightening WAL test cushions may also limit the ability of CLOs to participate in loan refinancing requests and maturity amendments. In fact, this limitation already appears to be the state of play in some cases, with those CLOs with lower or failing WAL test cushions generally holding the largest proportion of nearer-term maturing assets in their portfolios.
Is There An Alternative For CLOs?
Possibly. Some CLOs include language in their documentation that enables them to modify the WAL test, for example by extending the date by 18 months or less, providing much-needed relief as WAL test cushions continue to thin. Usually these conditions are found under section 14(c) of "Modification and Waivers" and vary across CLOs, but typically include the following:
- Any extension to the WAL test by less than 18 months typically only requires consent from the then controlling class of notes. For more than 18 months, consent from each class of note is required;
- A rating agency confirmation requirement; and
- The WAL test may be amended on more than one occasion provided that the aggregate of all modifications do not extend a number of months past the issue date of the transaction.
In our view, variations in WAL test extensions will likely become a more common feature in CLO transactions going forward, either in the form of a modification (as above) or otherwise in-built into CLO test metrics.
Scenario Analysis: Tighter Financing Conditions For Leverage Loan Borrowers In A Downturn
European CLO transactions have continued to show strong performance and resilience through several downturns, the most recent being the global COVID-19 pandemic (see "COVID-19 Tests The Resilience Of European CLOs In 2020," published on Dec. 1, 2020).
CLOs now face their next challenge, this time in the form of a global economic downturn and high inflation, both of which are likely to affect the refinancing prospects for the leveraged finance and CLO markets.
To explore how CLO ratings might perform under challenging loan refinancing scenarios, we performed an analysis based on a series of hypothetical stresses with different levels of CLO asset defaults, trading losses, downgrades, and recovery timings.
We highlight the following:
- The stresses we selected for each scenario are hypothetical and are not meant to be predictive or part of any outlook statement.
- The stresses are not meant to calibrate to any of the economic scenarios we associate with our rating definitions.
- The results are based on the application of the models we use to rate CLOs. A rating committee applying the full breadth of S&P Global Ratings' criteria and including qualitative factors might, in certain instances, assign a different rating than the quantitative analysis alone would indicate.
Running the stress scenario
The Appendix below outlines our assumptions for creating a generic CLO structure and portfolio that generally resembles similar European structures that we rate. In drawing out these assumptions, we focus on key structural and portfolio parameters that most closely resemble a typical CLO transaction (see "Appendix" and table 3).
Table 1 outlines the scenarios that we considered for the ratings stress test and some of the assumptions underlying these scenarios.
|Stress Test Scenarios|
|One||5% par loss; immediate recovery assumption|
|Two||5% par loss; 5% of 'B-' transition to 'CCC'; liquidity stress via one year delayed recovery assumption|
|Three||5% par loss; 15% 'B-' transition to 'CCC'; liquidity stress via two year delayed recorvery assumption|
|Four||10% par loss; 7.5% 'B-' transition to 'CCC'; immediate recovery assumption|
To put these assumptions (and the following results) into perspective, we firstly take a conservative view that these stresses apply immediately rather than gradually over time. Secondly, all of our stress test scenarios assume a "par loss" rate rather than an outright default rate to our hypothetical CLO transaction, which is a common assumption used in stress test scenario analyses. As highlighted above, this is because CLO managers may simply sell assets with relatively weaker financing opportunities to help minimize losses, rather than hold the asset to the point of default and risk crystalizing larger losses. We therefore assume scenarios where the CLO experiences an overall par loss, resulting from a combination of both trading losses and defaults.
Thirdly, we make a simplified assumption that the weighted-average spread (WAS) generated by the underlying portfolio remains unchanged during the transaction's life. Of course, the portfolio's overall notional spread may increase for a period of time as lenders accept refinancing proposals at higher rates. While not given here, our analysis notes improved results, especially at lower rating levels, if we assume incremental increases in the WAS.
Finally, scenarios 2 and 3 embed a delay assumption to the receipt of recovery proceeds from defaulted assets in an attempt to reflect a CLO transaction's sensitivity to liquidity constraints. Our analysis highlights how--to a large extent--CLO performance is sensitive to these cash receipts under the stresses applied, whether it's to aid timely interest payment on senior notes, bond duration, or the length of time deferrable notes pay-in-kind. Once again, we could have assumed a reduction in WAS instead, but interest on CLO debt is typically covered by a number of multiples, and a fall in WAS, in our view, would not be conducive to an environment undergoing tightening financing conditions.
For details of the cash flow profiles in this analysis, charts 8, 9, and 10 in the Appendix reproduce the repayment profile for some of the CLO bonds under each of the stress test scenarios.
European CLO ratings demonstrate high resiliency
|Rating Movement For All Ratings Under Stress Scenarios|
|Stress test scenario|
|Note: For B- rated notes, our ratings analysis makes additional considerations before assigning ratings in the ‘CCC’ category, and we would assign a 'B-' rating if the criteria for assigning a 'CCC' category rating are not met. We have therefore not included the results for the class F notes in this scenario analysis.|
Overall, the ratings impact is generally lower for investment-grade CLO ratings than for speculative-grade ratings, and the ratings overall demonstrate considerable resiliency. Under these stress scenarios, 'BBB' and 'BB-' ratings experience the largest movement, although none of the rated notes suffer losses in any of the four stress scenarios despite the magnitude of the stresses.
The note factor for the most senior classes of notes generally shows a consistent repayment profile, though are most significantly affected when the liquidity stress is applied under scenarios 2 and 3 (see chart 8 in the Appendix for the 'AAA'-rated class A notes). The curves under the liquidity stresses break away from all other scenarios in the beginning years, but then gradually converge as a result of back-ended principal repayments.
The repayment profile for the lower rated classes of notes highlights that they effectively diverge from their base case from day 1 (see charts 9 and 10 in the Appendix for the class D ('BBB'-rated) and class E ('BB-'-rated) notes, respectively). These notes immediately pay-in-kind on their bonds under the stress scenarios (while the more senior classes are deleveraging), and the rate of compounding increases the most where the liquidity stresses are applied. Noting the significant duration risk verses the base case, the repayment profiles in all scenarios converge toward the latter years and deleverage junior CLO bonds at a significant rate, driven by back-ended principal repayments following repayment of senior CLO bonds.
Tell Us Which Scenario You'd Like To See
In an effort to provide market participants with further transparency and analytical education into CLO ratings performance, we invite you to outline which scenario you would be most interested in seeing from S&P Global Ratings. Simply submit your request using the email address below, outlining the assumptions similar to the ones given under table 1.
Feedback will be limited to the same results provided in this publication, specifically (1) rating movement as shown in table 2 and (2) the note(s) repayment profile as given in charts 8-10.
Stress test scenario: CLO portfolio and structure assumptions
For the stress test, we created a generic CLO structure and portfolio that are typical of the European CLO structures that we rate. In drawing out these assumptions, we focus on key structural and portfolio parameters, including but not limited to the following.
For the CLO structure:
- Credit enhancement levels;
- CLO note spreads and coupon (setting aside the recent spread widening and those witnessed in 2020);
- Overcollateralization tests and cushions; and
- Key dates, including length of the reinvestment period.
For the portfolio:
- A portfolio of the top 100 names across European CLOs (by notional amount), weighted in exposure similar to their exposure in CLOs overall;
- WAS; and
- Weighted-average recovery rate assumptions.
Table 3 produces the following CLO transaction structure and portfolio assumptions for the stress test:
Note repayment profiles
Related Criteria And Research
- CLO Pulse Q1 2022: Sector Averages Of Reinvesting European CLO Assets, July 13, 2022
- COVID-19 Tests The Resilience Of European CLOs In 2020, Dec. 1, 2020
This report does not constitute a rating action.
|Primary Credit Analyst:||Sandeep Chana, London + 44 20 7176 3923;
|Secondary Contact:||Emanuele Tamburrano, London + 44 20 7176 3825;
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