March 6, 2020 / 12:22 PM / a month ago

CLOs face pressure on credit downgrades

LONDON, March 6 (LPC) - CLO managers are coming under pressure as increasing number of borrowers are expected to face downgrades in light of economic headwinds and the fallout from the coronavirus.

Credit quality has been deteriorating over the last few years due to slower economic growth, but the pace of downgrades has accelerated in recent months even without taking into account of virus effect.

The downgrade-to-upgrade ratio for speculative-grade companies increased sharply to 3.8 times by end of last year from 1.5 times a year ago, with 2019 recording the highest number of downgrades since 2014, according to Moody’s.

“We saw more downgrades in the second half of last year and there’s a likelihood it will carry over to this year,” said Fabrizio Marchesi, vice president and senior analyst at Moody’s.

While European leveraged credits such as UK drinking water purification provider Waterlogic, French pharmaceutical group Novacap, Belgian chemical company Allnex and Israeli plastic furniture maker Keter all have been downgraded in recent months, the outlook downgrade of UK petrol station operator EG Group on Tuesday attracted most attention from CLO mangers.

EG is a well-known credit in the European leveraged market. It raised a €2.85bn-equivalent term loan B to back its acquisition of over 2,000 Esso sites in Italy and Germany in 2018.

“It’s a widely held name. Some have a very large position in multiple vehicles,” said a CLO manager.


Though EG Group’s corporate rating remains at B2, its negative outlook trigged by a weaker earning generation and risk related to its buying spree indicated a further potential downgrade to B3, just a notch above Caa1, a category that CLO mangers try to avoid.

“CLOs have a limited Triple C basket. They can withstand some downgrades but not many before they have to start selling,” a senior investor said.

Downgrades matter to money managers because that could break CLOs’ weighted average rating factors (WARF), which is one of the collateral quality tests that CLOs are required to maintain or improve throughout the life of a fund. The other tests include weight average spread (WAS) and diversity score.

“The first thing that would happen with a downgrade is the WARF of the CLO weakening, and the number getting higher. That’s the trend we have seen in the market for some time,” said James Morton, vice president and senior analyst at Moody’s.

The negative outlook led to a sell-off of EG loans in the secondary market. The average bids on EG’s euro loan dropped by 158bp on the day of downgrade to 94.8 from 96.38 a day before, according to Refinitiv LPC.

“You can’t easily get out,” said the CLO manager. “Other CLO buyers who don’t have position won’t touch it. Separated managed accounts like Japanese money, they won’t go in for too low rated pieces. You just don’t have natural buyers.”


An individual credit downgrade won’t immediately break the WARF test, but the coronavirus spreading in Europe has complicated the situation as risks of a widespread of unexpected downgrade hike. “We expect more negative outlooks and rating watches negative to accompany new information releases and management updates,” said in a report by Fitch Ratings, which estimated a quarter of EMEA’s leveraged finance portfolio is exposed to the virus risk.

Generally, when WARF gets worse, CLO managers can widen the WAS and diversity score to get the problem solved.

However, CLO managers could have their hands tied when the loan spreads in the portfolio drop and there is limited room to improve the diversity score. “The problem is a lot of repricings in the past few weeks have compressed the spreads. The only way you can hopefully get out is to add diversity. But diversity could diminish your return and the limited choice in the European market make the diversity hard to improve.” said another CLO manager. “It’s really boxing you in.” (Editing by Chris Mangham)

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