European collateralized loan obligations (Euro CLOs) have demonstrated strong credit performance since the beginning of the century, with minimal defaults, low loss rates, and a large proportion of ratings remaining stable in most years (see "Default, Transition, And Recovery: 2021 Annual Global Leveraged Loan CLO Default And Rating Transition Study," published on Oct. 31, 2022).

In particular, Euro CLO 2.0 transactions (those issued after 2013) that S&P Global Ratings rates have continued to exhibit stable performance with no defaults to date. These transactions also performed well during the COVID-19 pandemic: we placed only 39 European CLO tranches on CreditWatch negative during 2020, of which 25 tranches (representing less than 1.5% of our rated tranches) were downgraded by an average of one notch. The tranches that were downgraded were mainly in the 'BB' rating category, with no rating downgrades in the 'AAA', 'AA', and 'A' rating categories

Nevertheless, the European CLO market continues to face headwinds, ranging from lingering supply-chain issues post-pandemic, high energy costs, inflationary pressures, and rising interest rates amid an environment of tighter financing conditions, all of which adds pressure to corporate lenders, increasing the potential for negative rating actions.

We have previously explored how our Euro CLO 2.0 ratings might perform under various hypothetical scenarios by stressing specific variables, including the potential effect of Brexit in 2016, COVID-19-pandemic related stresses in 2020, and more recently, the shrinking maturity wall (see "Related Research"). In this report, we tested the resiliency of Euro 2.0 CLO ratings under increased asset downgrades and par losses.

Stress Analysis Scenario Details

For this scenario analysis, we stressed Euro 2.0 CLOs by applying a one-notch, two-notch, three-notch, and four-notch downgrade to all assets held within each portfolio. We also looked at the effect of varying amounts of par losses in the underlying CLO collateral portfolios. Finally, we ran a set of scenario tests in which we combined a one-notch downgrade stress with par losses to see the combined effect on CLO ratings. Although these stress scenarios are somewhat extreme and potentially implausible, they provide a health check of the senior tranches.

The scenarios are divided in three categories:

• Downgrades impacting credit risk (scenarios 1 to 3);
• Par losses impacting cash flow risk (scenarios 4 to 11); and
• A combination of both (scenarios 12 and 13).

Scenario Stress Test Results

All of the scenario test results are accessible in greater detail in the link below:

https://www.spglobal.com/ratings/en/research-insights/sector-intelligence/interactives/european-clo-interactive-scenario-analysis-2022

Scenario Stress Test Recap

Table 1 summarizes the results of the scenario stresses we ran for the reinvesting 'AAA'-rated tranches. Overall, the results of the tests indicate that while these scenarios unsurprisingly indicate a rating downgrade, the rating effect was limited to the 'AA'-rating category in most cases (including those where all CLO assets were downgraded by three notches or experienced 15% par loss). In all scenarios but one relating to a par-loss of 30%, the 'AAA'-rated tranches remained in the investment grade category.

Overall, the results of these tests indicate that, even under increased economic stress, senior 'AAA'-rated European CLO 2.0 tranches demonstrate significant stability, with most tranches only downgraded to the 'AA' category in most scenarios. The results also show that lower-rated tranches may be more affected and suffer steeper downgrades, as we would expect under such scenarios. The results provide information about how our CLO ratings might perform during periods of significant economic stress and highlight the fundamental strengths of CLOs as a securitization platform.

Table 1

Assumptions For Running The Stress Scenarios

For this scenario analysis, we focused on European CLO 2.0 transactions of broadly syndicated loans (BSL) that have become effective and that have started issuing trustee reports as of the end of second-quarter 2022. Our dataset included 261 Euro CLO 2.0 transactions that we currently rate and that we consider to be a representative sample of the rest of the CLO 2.0s we have rated since the beginning of 2013.

Following the application of the additional stresses, we conducted our credit and cash flow analysis by applying our criteria for corporate cash flow CDOs (see "Global Methodology And Assumptions For CLOs And Corporate CDOs," published on June 21, 2019). We applied our standard cash flow stress scenarios, using four different default patterns, in conjunction with different interest rate stress scenarios for each liability rating category. The cash flows were run for a total of 1,828 rated tranches from these 261 CLOs.

Table 2

See "Appendix" for further details on the models used to determine the outcome of the stresses applied.

Rating downgrade (scenarios 1-4)

For the rating downgrade scenarios, we stressed our CLO ratings by uniformly lowering the ratings assigned to each CLO asset in the Euro 2.0 CLOs by one notch, two notches, three notches, and then four notches. The notched ratings are floored at 'CCC-', while CLO assets currently rated 'CCC-', 'CC', 'SD', or 'D' are maintained at those levels.

These scenarios would affect our CLO credit analysis, leading to an increase in the expected default rate for each CLO's underlying collateral portfolio. This is represented by an increase in the scenario default rates (SDRs) at each different rating.

To illustrate with an example CLO in our sample, the base case 'AAA' SDR of 63% (i.e., the expected gross default rates for the CLO portfolio over the life of the transaction) increases to 70% under scenario 1. There is no effect on our cash flow analysis.

Par loss (scenarios 5-11)

For the par loss scenarios, we stressed our CLO ratings by assuming a portfolio loss rate ranging from 5% to 30%. Instead of assuming different default rates that also necessitate varying recovery assumptions, we assumed an overall 'par loss' rate in our scenarios to capture the combination of both trading losses and defaults. This par loss stress applies immediately and reduces the transaction's available credit enhancement from Day 1. Therefore, this stress is in addition to the level of defaults/losses applied in our cash flow model for the life of the transaction.

Under these scenarios, there is no effect on our CLO credit analysis. Instead, this affects our cash flow analysis by decreasing the CLO's break-even default rates (BDRs). The BDRs represent the maximum default rate in the underlying portfolio that the tranche can withstand and still pay timely interest and ultimate principal.

To illustrate with an example CLO in our sample, the base case BDR (without any stress) for the rated class A tranche is 69% and the base case 'AAA' SDR is 63%. This means that this tranche can sustain a lifetime default rate of 69%. Given that this is greater than the expected lifetime level of defaults under a 'AAA' stress (63%), this tranche can achieve a rating of 'AAA'. Under scenario 5, the BDR falls to 64% from 69%, i.e., the level of defaults it can sustain has decreased. Nevertheless, given that the 'AAA' SDR remains unchanged at 63%, there remains a positive cushion of 1% (BDR 64% - SDR 63% = rating cushion 1%). Therefore, the ratings in this CLO remain unchanged under scenario 5.

Rating downgrade and par loss(scenarios 12-13)

For scenarios 12 and 13, we stressed our CLO ratings by combining scenario 1 with scenario 5 and scenario 7, respectively--i.e. we assumed all CLO assets are downgraded by one notch and that the portfolios incur a par loss of either 5% or 10%.

Some limitations and caveats to our stress testing

Before diving into the results, it's worth highlighting a few caveats:

• The stresses we selected for each scenario are hypothetical and are not meant to be predictive or part of any outlook statement.
• The stresses we selected are not meant to calibrate to any of the economic scenarios we associate with our ratings in "Understanding Standard & Poor's Ratings Definitions," published June 3, 2009.
• 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.
• In particular, the implied rating transitions to the 'CCC' and 'CC' rating category are based solely on our model results. Our ratings analysis makes additional considerations before assigning ratings in the 'CCC' and 'CC' rating category (see "General Criteria: Criteria For Assigning ‘CCC+’, ‘CCC’, ‘CCC-‘, And ‘CC’ Ratings," published on Jan. 18, 2018).

Conclusion

The current economic environment is challenging for European corporates, especially in the non-investment grade spaces. This could lead to a potential deterioration of the credit metrics, including lower ratings, and higher defaults or losses incurred as a result of trading, which could translate into negative rating actions for European CLOs. Although several of the scenarios we have tested can be deemed as implausible, they provide a good picture on the strength of the European CLO product, especially for the senior rated tranches.

The authors would like to thank Dmytro Saykovskyi, Mohammed Aftab, and Victoria Blaivas for their modeling contributions to this report.

Appendix

For our scenario testing, we generated a quantitative analysis for our Euro 2.0 CLOs using the same tools we use when rating these transactions. Our CDO Evaluator credit model assesses the overall credit quality of a portfolio of assets based on the rating and maturity of each asset, as well as the correlation between assets, and produces expected default rates at different rating levels (see "Credit Rating Model: CDO Evaluator," published on May 8, 2020). This is determined by the SDR generated by the credit model, which represents the minimum level of portfolio defaults we expect each CDO tranche to be able to support for its specific rating level.

Our S&P Cash Flow Evaluator model assesses the ability of tranches in a given CLO to withstand loss rates under various interest rate and default timing scenarios (see "Credit Rating Model: CDO Evaluator Engine," published on June 21, 2019). This is determined by the BDR, which represents our estimate of the maximum level of gross defaults, based on our stress assumptions, that a tranche can withstand and still fully repay the noteholders. Although ratings are assigned by committee and our criteria encompass a variety of qualitative and quantitative components, the output of these two models for a given CLO portfolio and structure should provide a strong indication of the ratings we would assign under a given scenario.

Specifically, when assigning ratings on CLO notes, our analysis considers the "rating cushion" for each CLO liability rating level. The rating cushion is the excess of the tranche BDR above the SDR at the assigned rating level for a given class of note. The rating cushions typically vary for each CLO rating level depending on the CLO's capital structure and the composition of its underlying portfolio.

In our view, the rating cushion forms a key component of the results generated from the stress tests because the greater the rating cushion built into a CLO tranche from inception, the more credit protection the tranche has available to support itself during adverse events.

Notes

We make both CDO Evaluator and S&P Cash Flow Evaluator available to CLO market participants to use in order to provide transparency into our ratings process. Visit our Web site, https://www.spglobalratings360.com (registration required) to request permission to download one or both models.

Related Criteria

• S&P Global Ratings Definitions, Nov. 10, 2021
• Credit Rating Model: CDO Evaluator, May 8, 2020
• Credit Rating Model: CDO Evaluator Engine, June 21, 2019
• Global Methodology And Assumptions For CLOs And Corporate CDOs, June 21, 2019
• Principles of Credit Ratings, Feb. 16, 2011

Related Research

• Default, Transition, And Recovery: 2021 Annual Global Leveraged Loan CLO Default And Rating Transition Study, Oct. 31, 2022
• European CLOs: Is The Loan Maturity Wall CLOsing In?, Sept. 1, 2022
• Scenario Analysis: How Credit Distress Due To COVID-19 Could Affect European CLO Ratings, April 2, 2020
• CDO Spotlight: Shock To The System: What Would It Take To Break A 'AAA' Euro CLO 2.0 Tranche, Oct. 14, 2016
• Shock To The System: Additional Stress Tests For European CLO 2.0 Ratings Show Continued Resiliency, May 31, 2016