European collateral loan obligations (CLOs) typically benefit from portfolio diversification, both from an issuer and sector perspective, with CLO managers maintaining portfolios of leveraged loans that have an average exposure to 161 different corporate issuers operating across 39 different industry categories.

In this publication, we examine the aggregate asset quality held by European CLOs, observed through key credit metrics and consolidated by S&P Global Ratings' CLO industry sectors. Specifically, this edition of sector average metrics for European CLO assets focuses on loans issued by 709 corporate issuers, which represents over 95% of the assets under management (AUM) held in reinvesting European CLOs rated by S&P Global Ratings as reported on Sept. 30, 2022. We calculated the average metrics for all floating-rate assets with both an S&P Global Ratings' credit rating and an S&P Global Ratings' recovery rating (the S&P Global Ratings-rated CLO assets), weighted by the euro notional exposure to each asset.

European CLO Credit Quality Remains Unchanged While Increasing WAS On Lowering WAP: Key Changes To Credit Metrics

Based on our review of 2022 data and looking into the third quarter, the average reinvesting European CLO portfolio rated by S&P Global Ratings exhibited the following changes:

• S&P Global Ratings' weighted-average rating factor (SPWARF) remained broadly unchanged compared with the previous quarter, falling to 2,869 from 2,870. At the same time, however, underlying CLO loan prices exhibited continued declines, driven by macroeconomic headwinds and deterioration in the general market sentiment, in our view (see chart 1).
• Cash flow pressures at asset level have started mounting across sectors, affecting not only consumer goods, commodity chemicals, capital goods, and energy-heavy sectors. Median EBITDA interest coverage for European CLO obligors is 3.3x, which is 0.5 times lower than the previous quarter as persistently high input inflation, slower price rises, and rising interest costs have begun affecting free cash flows. The average unstressed recovery rating is predominantly '3' (50%-70%), constituting 85% of CLO portfolio assets held.
• Weighted average par exposure in the European rated CLO universe has remained broadly stable, with an increased barbell effect. Holdings of debt tranches trading above 90, by number and €-equivalent exposure, have increased to 57.5% of the overall portfolio. This is offset by rising exposure to tranches trading below 80. Underperforming debt trances, defined as trading below 70, have also increased to 2.4% of the overall portfolio.
• Obligors on negative outlook or CreditWatch negative comprise 10% of the overall portfolio holdings, as downside risks on cash flow generation increased in Europe, driven by a combination of inflation-driven margin compression, softening demand in certain sectors, and rising interest rates.

Chart 1

Evolution Of The European CLO Market In 2022

Inflation, rising interest rates, geopolitical uncertainty, supply chain disruptions, and an energy crisis dominated the economic landscape in 2022, contributing to a challenging year for European CLO issuance. As a result, CLO structures and portfolios have had to accommodate to the market landscape and generate demand for CLO investments.

Credit enhancement evolved in 2022, similar to 2020

Given the economic uncertainty, average credit enhancement levels increased across all rating levels of priced European CLOs in 2022 to provide further protection to CLO structures, a similar trend observed during the COVID-19 pandemic. Based on CLOs rated by S&P Global Ratings, 'AAA' credit enhancement increased to 40.64% in fourth-quarter 2022 from an average of 38.78% in first-quarter 2022; however, the largest relative increase was seen at the 'BB-' level, which increased to 13.63% in fourth-quarter 2022 from 9.75% in first-quarter 2022. Notwithstanding the above trend, 'AAA', 'A', and 'BBB' credit enhancement levels observed some mean reversion in fourth-quarter 2022, marginally falling from their highs during the same period. This perhaps resulted from further structural optimization to improve CLO funding costs.

Chart 2

Shorter-duration CLOs appeal to investors in 2022, reducing the length of reinvestment periods

Over the course of 2022, the average length of the reinvestment period for newly issued European CLOs reduced to 3.0 years in December 2022 from 4.8 years in February 2022, aiding CLO funding costs in a spread-widening environment and appealing to investors in search of short-duration risk. Unsurprisingly, March 2022 signaled the starting point for the decline, with the first five CLOs to price averaging a reinvestment period of 4.3 years compared with the following five CLOs averaging a reinvestment period of only 3.4 years.

This downward trend continued through April and May, but reversed in June, as represented by only one CLO, Providus CLO VII DAC, with a 5-year reinvestment period. Mean-reversion continued during July, driven by Jubilee 2022-XXVI DAC, Harvest CLO XXIX DAC, and Clonmore Park CLO DAC, which had reinvestment periods of 4.75, 4.5, and 4.5 years, respectively; however, the downward trend followed through August and September. October was dominated by shorter-duration issuance, with Barings Euro CLO 2022-1 DAC, Grosvenor Place 2022-1 CLO DAC, and Neuberger Berman Loan Advisors Euro CLO 5 DAC all pricing with one-year reinvestment periods, bringing the October average down to 2.15 years. In November, CVC Cordatus Loan Fund XXVI DAC and Dryden 103 Euro CLO 2021 DAC priced with reinvestment periods of five years, contributing to an average of 4.21 years for the month; however, shorter reinvestment periods then persisted in December to close out the year.

Chart 3

CLO funding costs

CLO funding costs experienced a rising trend during 2022. On average, CLO funding costs rose to 3.19% in December 2022 from 1.83% at the start of the year, representing a 74% increase. Liability costs peaked at 3.26% in October and remained reasonably stable through fourth-quarter 2022 (see chart 4).

As CLO liability costs continued to rise over the course of the year, so did weighted-average spread (WAS) modelling assumptions, arguably to keep pace with the costs secured on CLO structures and improve the basis between asset spreads and funding costs (see chart 4).

Chart 4

The comparison presented below between the monthly average weighted-average cost of debt levels and the monthly average weighted-average spread levels suggests that the difference between these two variables continuously narrowed since the start of the year; and, though bonds are increasing in portfolios, they are still very much a minority. As such, it is reasonable to assume that later 2022 vintage CLOs will be the most likely candidates for refinancing if such opportunities present themselves.

Chart 5

SPWARF improved for newly issued CLOs

SPWARF scores improved as new CLOs were issued during 2022 and CLO managers built more protective portfolios as they prepare for 2023. At the same time, this coincided with higher weighted-average recovery prospects (see chart 6).

In our view, CLO managers have adjusted their portfolios and strategies to protect credit quality as they navigate the headwinds that 2023 will present, especially since they will be looking to declare their CLOs effective this year. Below we demonstrate the closing SPWARFs and weighted average recovery rates (WARRs) of CLOs rated by S&P Global Ratings that priced in 2022.

Chart 6

Mounting downside risks push CLOs to increased diversification

The median debt-to-EBITDA and interest coverage ratios for issuers present in European CLOs worsened marginally to 6.3x and 3.3x, respectively, in third-quarter 2022. There were five non-performing assets in portfolios, two of which would have emerged from restructuring by January 2023, and one (Crown Finance US Inc.; part of Cineworld Group Plc) will likely go through a prolonged emergence from Chapter 11.

The universe of 'B-' and 'CCC' category rated issuers was relatively stable during third-quarter 2022. However, increased squeezes on profitability, degrading free operating cash flows, and rapidly approaching refinancing walls for some, have meant that downgrades will put pressure on CLOs in following quarters, similar to that seen in 2020. In our view, it is misleading to extrapolate sector themes, as rating actions are intimately linked to the obligor's fundamentals, its positioning, and its exposure to each of the risks. Upgrades into the 'B-' category largely came from the entertainment and leisure sectors, as smaller credits start are emerging from the long shadow cast by the pandemic in 2020.

Furthermore, par values continued to erode across CLO portfolios in the third quarter. While the number of tranches held was broadly similar, at about 950 loans and bonds, the par value average was 1 point below, as October saw peak spreads and yields in loan and bond markets alike. Having said that, on a weighted average basis, the par differential was broadly equal to the previous quarter as careful rebalancing via trading took place. Tranches trading above 90 increased to 57.5% of the portfolio, compared to 55% in the previous quarter. The main driver was the flight to quality both in terms of fundamentals and technical, with liquidity of the underlying tranche being a key consideration for trading decisions.

Tranches trading between 70 and 80, which is the new grey area for highlighting underperforming credits and duration exposure, increased to 9.3% in the third quarter from 6.9% in the second quarter. Likewise, exposure to underperforming credit (i.e., tranches trading below 70) rose to 2.4% of the portfolio in the third quarter, compared to 1.4% in the second quarter. These trends point to the rising risk of distressed credit evolution and active trading strategies, as well as the ability to follow one's investment should a distressed situation arise--all of which are key in the next year or so in managing CLO performance and their ratings stability.

Chart 7

Chart 8

European CLOs continue to work through their existing 'CCC' exposures while simultaneously navigating instances of downward rating pressures on underlying credits, with now just above 20% of all European CLOs comprising on aggregate more than 7.5% exposure in 'CCC' rated obligors (see chart 9).

Chart 9

This goes hand-in-hand with a small rise in CLO portfolio exposure to obligors on CreditWatch negative. To put this into context, however, average exposure levels to obligors on CreditWatch negative remain below 1% (see chart 10).

Chart 10

Sector Averages Of Reinvesting European CLO Assets

Before diving deeper into the results, it is worth highlighting the following caveats.

We calculated the average metrics for all floating-rate assets with both an S&P Global Ratings' credit rating and an S&P Global Ratings' recovery rating (the S&P Global Ratings-rated CLO assets), weighted by the euro notional exposure to each asset.

Our analysis of reinvesting euro CLO portfolio at the end of each quarter exposure include average values over time for key credit metrics (see table 1, as well as the Appendix for calculation specifics). Those metrics are:

• Issuer count: the obligor count across all European CLO transactions;
• SPWARF: the S&P Global Ratings' weighted-average rating factor for the CLO collateral, with a higher value indicating a lower average rating across transactions;
• WARR: the weighted-average recovery rate for the loans in the portfolios, as implied by the corporate recovery rating we have assigned to each loan;
• WAS: the weighted-average spread over EURBOR of the loans in each CLO portfolio; and
• WAP: the weighted-average price of the loans in each CLO portfolio based on market sources.

Table 1

CLO Assets Weighted By Exposure

Weighted-average metrics

Our analysis focuses on a pool of loans issued by 709 corporate issuers, representing over 95% of the AUM currently held in reinvesting European CLOs that we rate. For each sector, we calculated the average metrics for all of the assets that we rate, weighted by the euro notional exposure to each asset. These metrics include the SPWARF, WARR, WAS, and WAP (see table 1 and the Appendix).

Average metrics per industry

The corporate issuers operating within various industries have different credit profiles, and the loans they issue also have different characteristics. Using CLO exposures for these CLO assets, we calculated the average metrics described in the Appendix, weighted by par, across the various Global Industry Classification Standard (GICS) sectors.

Table 2

Ratings bias per GICS sector

At the end of the third quarter of 2022, 10.46% of S&P Global Ratings-rated CLO assets had a negative rating bias (i.e., ratings from issuers with a negative outlook, or on CreditWatch negative), down from the 21.70% at the start of 2020 and down from 11.72% at the start of the third quarter of 2022. We also examined the breakdown between negative bias, positive bias, and stable for 24 GICS sectors, each weighted by euro notional exposure (see chart 11). The bias breakdown per GICS sector can be sensitive to the rating bias of the issuers with higher CLO exposure, particularly the GICS sectors with fewer obligors.

Chart 11

European CLOs' key metrics

In response to investors' growing interest following the COVID-19 pandemic and ongoing credit effects on companies and European CLOs, S&P Global Ratings is publishing a regularly updated list of rating actions we have taken globally on nonfinancial corporations that have had an effect on European CLOs, and a summary of how European CLOs have been affected with key benchmarks.

The report, titled "Weekly European CLO Update," covers all currently S&P Global Ratings' rated European CLOs, including those that are in their reinvestment period. The rating actions and benchmarks will be refreshed weekly to provide an update of the European CLO market.

To compare European CLO data each week, S&P Global Ratings provides you with an EMEA CLO Collateral Managers Dashboard. This dashboard is a single snapshot view of CLO-critical credit risk factors where you can examine, compare, and benchmark individual S&P Global Ratings' rated European CLOs.

https://www.spglobal.com/ratings/en/research-insights/topics/powerbinew

Appendix

The scope: S&P Global Ratings-rated CLO assets, representing 95% of AUM in reinvesting European CLOs

The information is based on the aggregation of CLO exposures to corporate issuers as reported in the third-quarter 2022 trustee reports of reinvesting European CLOs.

S&P Global Ratings' corporate group issues and maintains credit ratings for most companies that issue the loans held in CLOs. As part of our credit rating process, we capture various ratios of the issuer at the time of the rating. We also issue and maintain recovery ratings for most loans held in CLOs.

Almost all of the companies that issue loans held in European CLOs are classified within the GICS. These industry classifications are utilized within the CDO Evaluator credit model, which S&P Global Ratings' structured finance group uses in its rating process for CLOs.

We aggregate CLO exposures reported in trustee reports available as of the end of the third quarter of 2022 and calculate various metrics, weighted by the outstanding par amount of exposures and stratified by the GICS classification of the issuer of the loans. Our analysis focuses on those assets with an S&P Global Ratings' credit rating and an S&P Global Ratings' recovery rating. These S&P Global Ratings-rated CLO assets were issued by 709 corporate issuers operating across various GICS industries and represent over 95% of the total par of the CLOs aggregated in this third-quarter 2022 update. The credit rating, recovery rating, spread, price, and leverage ratio values of these floating S&P Global Ratings-rated CLO assets were used to calculate the averages outlined in tables 1 and 2.

The six metrics we use in our analysis are listed below.

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

The SPWARF of a CLO portfolio provides an indication of the overall credit rating distribution of the portfolio, weighted by each asset's par balance. The rating factor for each of the portfolio assets is determined by S&P Global Ratings' credit rating (or implied rating) and the rating factor. (An individual asset's S&P Global Ratings rating factor is the five-year default rate, given the asset's S&P Global Ratings credit rating and the default table in the corporate CDO criteria, multiplied by 10,000.) The SPWARF is calculated by multiplying the par balance of each collateral obligation by the S&P Global Ratings rating factor (including exposures to issuers with a non-performing rating: 'CC', 'SD' and 'D', each with a rating factor of 10,000), then summing the total for the portfolio and dividing this result by the aggregate principal balance of the collateral obligations included in the calculation.

Weighted-average recovery rate (WARR)

For a subset of assets with an S&P Global Ratings recovery rating, the WARR is the sum product of each asset's recovery rate (the number within parenthesis to the right of the recovery rating) and the asset's par exposure as a percentage of the sum of the par of the subset of assets. For more details on S&P Global Ratings' recovery ratings, see "Recovery Rating Criteria For Speculative-Grade Corporate Issuers," published Dec. 7, 2016.

Weighted-average spread (WAS)

For a subset of floating-rate assets, the WAS is the sum product of each asset's nominal spread above the base rate and the asset's par exposure as a percentage of the sum of the par of the subset of assets.

Weighted-average price (WAP)

For a subset of assets with loan prices, the WAP is the sum product of each asset's price at the end of the quarter and the asset's par exposure as a percentage of the sum of the par of the subset of assets, where we have no loan price we assumed par at 100.

On CreditWatch negative

For those assets with a CreditWatch negative rating, the CreditWatch negative percentage is a proportion of the total CLO par amount considered in this analysis. This is also broken down per GICS sector (see table 2) as a total sum of the par of CLO GICS sector assets.

With negative outlook

For those assets with a negative outlook, the outlook percentage is a proportion of the total CLO par amount considered in this analysis. This is also broken down per GICS sector (see table 2) as a total sum of the par of CLO GICS sector assets.

Debt-to-EBITDA ratio

The leverage is based on the assumptions we make around debt and EBITDA, as used in our rating analysis:

• Debt: For the purpose of debt, we include items such as leases (both capital and operating), preferred shares (if deemed as debt-like), and accrued dividends.
• EBITDA: Our analysis generally adheres to what EBITDA stands for (earnings before interest, taxes, depreciation, and amortization). That is, revenue minus operating expenses plus depreciation and amortization, including noncurrent asset impairment and asset reversal.

Beyond that definition, our decision to include or exclude an activity from EBITDA depends on whether we consider that activity to be operating (e.g., acquisition-related or restructuring costs) or nonoperating (e.g., asset impairment or non-recurring items).

We generally calculate a company's credit ratios based on a three-year weighted average: the previous one year's results, our current-year forecast (incorporating any reported year-to-date results and our estimates for the remainder of the fiscal year), and our forecast for the next fiscal year. We apply weights to the core and supplemental ratios for the respective years to get to one final ratio for each metric. The length of the time series applied is dependent on the relative credit risk of the company and other qualitative factors, and the weighting of the time series varies according to transformational events.

For a subset of floating-rate assets, the debt-to-EBITDA ratio is the sum product of each asset's obligor nominal debt-to-EBITDA ratio and the asset's par exposure as a percentage of the sum of the par of the subset of assets.

Interest coverage ratio

For entities with weaker leverage assessments, interest coverage ratios can also shed light into the issuer's ability to service its debt.

We use the EBITDA value, as described above, divided by the carrying cost, or interest burden of the issuer's debt.

For a subset of floating-rate assets, the EBITDA interest coverage ratio is the sum product of each asset's obligor nominal EBITDA interest coverage and the asset's par exposure as a percentage of the sum of the par of the subset of assets.

Data coverage of the floating S&P Global Ratings-rated CLO assets listed in tables 1 and 2

Because we focus only on S&P Global Ratings-rated CLO assets (which represent over 95% of the overall AUM in the sample), by definition, we have full coverage of the data used to calculate the SPWARF, WARR, and WAS in tables 1 and 2. We have credit ratings, recovery ratings, and spread information for all loans issued by the 709 issuers as of Sept. 30, 2022, and each end of quarter in table 1.

Due to limitations within the various data sources, we did not have complete coverage regarding the price and leverage ratios for all the loans issued from all issuers. We were able to source pricing information for 99% of the loans and corporate leverage ratio information for 94% of the loans.