European collateral loan obligations (CLOs) typically benefit from portfolio diversification, from both an issuer and a sector perspective. CLO managers maintain portfolios of leveraged loans that have an average exposure to 160 different corporate issuers operating across 40 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 712 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 June 31, 2023. 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 Stabilizes: Key Changes To Credit Metrics

Based on our review of second-quarter (Q2) 2023 data and comparing against Q1 2023, 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) improved marginally to 2,884 in Q2 2023 compared with 2,903 in Q1 2023. At the same time, underlying CLO loan prices continue to reverse the recent decline, increasing to 94.28 in Q2 2023 compared with 93.12 in Q1 2023 (see chart 1).
• Cash flow pressures at the asset level have started mounting across sectors, affecting consumer goods, commodity chemicals, capital goods, and energy-heavy sectors, among others. Median EBITDA interest coverage for European CLO obligors is 2.9x, which is 0.1x lower than the previous quarter as persistently high input inflation, slower price rises, and rising interest costs continue affecting free cash flows. The average unstressed recovery rating is predominantly '3' (50%-70%), constituting 85% of CLO portfolio assets held.
• Obligors on negative outlook or CreditWatch negative continue to 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

Maturity Amendments

A maturity amendment is a modification to the terms of a loan or bond, to extend the obligation's stated maturity date. It is typically enacted through an amendment and restatement, a novation, or a substitution of an asset on substantially the same terms.

Maturity extensions increase the CLO's weighted-average life (WAL), which can ultimately delay the amortization of the notes after the reinvestment period. In addition, an obligation's maturity date extension beyond the maturity date of the CLO notes could expose the transaction to non-credit-related losses as the obligation may need to be sold before redeeming the notes. In our criteria we refer to these obligations as 'long-dated'.

Given the potential market value risk, a portfolio manager could vote in favor of a maturity amendment only in circumstances where:

• The WAL test is satisfied, or if not satisfied, it is maintained or improved; and
• The obligation's maturity date is not extended beyond the CLO notes' maturity date.

For CLO managers, a maturity amendment offers clear benefits of loan margin pick-up and continued exposure to a credit. As a result, CLO documentation often permits the manager to vote in favor of a maturity amendment, even if the WAL test is not satisfied (or maintained/improved), for up to a small percentage of the portfolio (typically 5% since the closing date).

More recently, we have seen additional flexibility in documentation permitting the manager to vote in favor of a maturity amendment even if it results in a long-dated obligation, under the following circumstances:

• If the maturity amendment is made in connection with an insolvency, bankruptcy, reorganization or other type of distressed exchange;
• If the portfolio manager intends to sell the obligation within a certain time period after the maturity amendment has been effected (typically 30 days);
• If, in the portfolio manager's reasonable judgment, not voting in favor of the amendment would likely have an adverse effect on the issuer or noteholders; or
• If the maturity amendment relates to an obligation that the manager has sold but not yet settled and the vote is made at the buyer's direction.

To mitigate the risk of long-dated obligations in the portfolio, CLOs usually take a haircut on the par value of these obligations to satisfy overcollateralization tests.

In most CLOs, the manager is not required to vote against a maturity amendment and can therefore abstain. However, a recent transaction included specific language stating that the manager must vote against a maturity amendment if, after the amendment, the WAL test is not satisfied, and if more than 5% of obligations, since the closing date, had been extended and for which the manager had abstained. However, this is rare among CLO documentation.

If the manager does not vote in favor of a maturity amendment, which is a majority vote, it will not be required to sell the obligation.

A so-called 'snooze drag' refers to a workaround CLO managers can use when they want to vote in favor of an amendment, but are unable to do so due to failing tests or reinvestment walls. The "snooze you lose" clause (as it's commonly referred to), found in the amendments and waivers section of the senior facilities agreement, is a borrower-friendly clause that was used in CLO 1.0 transactions to restructure during the financial crisis. The clause was introduced in sponsor transactions to neutralize stalling tactics by a handful of lenders who refused to vote in favor of a rescue package within the typical 10 business days. In its broadest, the clause permits the borrower to disregard lenders that fail to respond to a consent request from the numerator and denominator when determining majority or super majority, or when unanimous lender thresholds have been achieved. "Snooze you lose" language allowed rescue packages to be implemented quickly, arguably preserving value for the wider lender base, and ensuring the sponsor ownership continued as CLOs lacked restructuring teams or experience.

Fast forward to 2023, the snooze clause has been extended and amended. Its variations essentially permit CLOs managers that are unable to vote and accept the newly proposed refinancing package to abstain from voting and have their investment extended by a required minimum of people who form the majority vote.

The most conservative iteration of the snooze drag clause--which targets refinancings and restructurings--permits non-voting lenders to be excluded only when amending the payment schedule or maturity, though not other terms.

Other variations of the clause provide for nonvoting lenders to be not only excluded from the majority count, but to be excluded from the new transaction altogether--be it new facility offering, extension of maturity, or improvement of pricing. Nonvoting lenders would then also have to contend with the covenant alterations preferred (and structured) by the majority. In this variation, nonconsenting lenders could be stuck in a small stub of the original loan, and depending on how loose other terms in the senior facilities agreement are, could even be stripped of their collateral. This is something we have seen in the U.S., particularly in bond transactions, but attempts in Europe with loan tranches have so far been rare and all unsuccessful, at least in the widely syndicated loan space. Quite opposite, arrangers in most transactions aim to roll non-responsive lenders into the new and extended debt to facilitate a smoother transition.

In certain cases, this 'snooze drag' also permits for a manager's newer funds or those that have more room under tests, to participate in the new (oftentimes, super-senior) facility, offering attractive coupons (EURIBOR + 8.00%) for a shorter duration (one to two years), with better recovery prospects and clear priority at enforcement.

As with all clauses in legal documents, and as demonstrated by recent amends and extends, the consequence from, and interpretation of, legal language depends highly on the behavior of the parties involved. The existence of these clauses, often overlooked and not negotiated in the past, opens the possibility of dragging CLO managers into loan extensions that they would prefer to exit, or rather, the manager's ultimate investors may prefer them to exit. It may also find minority lenders' interest squeezed by those in the majority, particularly when new liquidity is required--though the credit may not be impaired--in the long term. Preempting an exit through a sale in the secondary market almost always crystalizes a par loss, however minimal, and some CLO managers may not wish to do that.

Refinancing at any cost?

Alleviation of recessionary risk for 2023 and still-robust earnings results overall paved the way for stability in spreads and yields in the secondary market. With primary issuance still subdued due to a lack of sponsor mergers and acquisition activity, refinancing and consequently maturity extensions, have been the key drivers of volume both for loans and bonds.

Average European CLO 'CCC' Exposure Increases

Average European CLO 'CCC' exposure decreased in Q2 2023 to 4.31% by September 2023 compared with 5.19% in June of the same year. Just over 17% of all European CLOs now comprise on aggregate more than 7.5% exposure to 'CCC' rated obligors (see chart 2).

Chart 2

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 3).

Chart 3

Sector Averages Of Reinvesting European CLO Assets

Before diving deeper into the results of our analysis, 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 European CLO portfolios at the end of each quarter exposure includes 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 Euro Interbank Offered Rate (EURIBOR) of the loans in each CLO portfolio.
• 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 712 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 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 Q2 2023, 9.95% 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 10.14% at the end of Q1 2023. We also examined the breakdown between negative bias, positive bias, and stable for 27 GICS sectors, each weighted by euro notional exposure (see chart 4). 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 4

European CLO key metrics

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

Our EMEA CLO Collateral Managers 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 Q2 2023 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 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 we use as part of our rating process for CLOs.

We aggregate CLO exposures reported in trustee reports available as of the end of Q2 2023 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 CLO assets were issued by 712 corporate issuers operating across various GICS industries and represent over 95% of the total par of the CLOs aggregated in this Q2 2023 update. We used the credit rating, recovery rating, spread, price, and leverage ratio values of these floating-rate CLO assets to calculate the averages outlined in tables 1 and 2.

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

Weighted-average life (WAL)

For a subset of assets, the WAL is the sum product of each asset's term to maturity and the asset's par exposure as a percentage of the sum of the par of the subset of assets.

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

The SPWARF of a CLO portfolio provides an indication of the portfolio's overall credit rating distribution, 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 'CC', 'SD', or 'D' rating, 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 rating on CreditWatch negative, the CreditWatch negative percentage of assets is a proportion of the total CLO par amount considered in this analysis. This is also split per GICS sector (see table 2) as a total sum of the par of CLO GICS sector assets.

With a 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 split 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 our debt and EBITDA assumptions 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. Credit ratings, recovery ratings, and spread information for all loans issued by the 712 issuers are as of June 30, 2023, and each quarter-end in table 1.

Due to various data source limitations, we had inadequate coverage of 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.