Speculative-grade European CLO tranches face ratings downgrades

A number of stress scenarios could see significant downgrades of some tranches.

Senior tranches of European collateralised loan obligations are likely to be resilient during the downturn, but lower-rated tranches may struggle in some scenarios, according to forecasts by S&P Global Ratings.

S&P has analysed a typical European CLO transaction in 10 hypothetical stress scenarios of varying severity covering: increase in CCC category rated assets, asset defaults, widespread asset downgrade, lower asset recovery ratings and higher correlation assumptions.

The analysis found that CLO rating migration would be greater further down the capital structure, with BB- rated tranches seeing a downgrade of between one and three rating notches in all but one of the 10 scenarios tested. Under two scenarios, a 10 percent portfolio default rate or a widespread asset downgrade, the rating drops to B-.

By contrast, the AAA-rated tranche holds onto its coveted rating in almost all scenarios, dropping to AA+ if there is a portfolio default rate of 10 percent, a one-notch downgrade to the whole portfolio or under higher correlation assumptions.

Key issues likely to face CLOs in the coming months include breaching thresholds for CCC rated assets. Typically, CLO documentation limits the proportion of CCC-rated assets to 7.5 percent of the portfolio. While current European CLO exposure to CCC assets remains low at less than 3 percent, the exposure to B- rated assets is far higher at 20 percent or even as high as 30 percent. S&P warned that if the ratings of these B- credits deteriorates to CCC then this could put many CLOs in danger of breaching their concentration limits.

S&P predicted that the default rate of European speculative-grade corporates could also rise. Despite being low at close to 2 percent for a decade, the ratings agency believes the economic stresses caused by the coronavirus pandemic could limit funding channels to vulnerable companies and force them to become insolvent. S&P believes that speculative-grade corporate credit default rates could rise to 8 percent over the next year.

The rating agency said its scenarios are intended to give a broad overview of how the pandemic crisis might affect European CLOs but makes a number of assumptions and limitations. A credit deterioration in the speculative-grade space would affect each transaction differently depending on underlying portfolio composition.

It also notes that CLO managers may be able to take action to navigate the stress scenario and mitigate the effect on CLO tranche ratings. S&P noted, historically, CLOs have seen less credit migration than the wider universe of speculative-grade credits, largely due to actions taken by managers.