By the Numbers
Downgrades in ‘B-‘ leveraged loans keep pressure on CLOs
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
With the pace of downgrades in ‘B-‘ leveraged loans showing no signs of slowing this year, investors in CLOs should keep an eye on the tests embedded in their deals designed to protect senior classes. Loans downgraded to ‘CCC’ or below look likely to keep pressure on a rising number of deals that may eventually divert cash flows from junior to senior classes. Deals with high ‘CCC’ asset exposures may trade at wider spreads in anticipation of cash flow diversion, although a few senior classes may end up getting upgraded due to CLOs’ structural protection.
Downgrades in ‘B-‘ loans this year have run at an annualized 22%
If the current trend continues, the total number of downgrades in ‘B-‘ issuers could reach approximately 22% by the end of 2023, according to projections based on the first five months of this year. So far this year, 29 ‘B-‘ issuers have slipped to lower ratings, representing 9% of total ‘B-‘ issuers in the leveraged loan index at 2022 year-end. This annualized level of downgrades would exceed the 22-year S&P median of 18% (Exhibit 1).
Exhibit 1: ‘B-‘ issuer downgrades in 2023 may exceed the last 22-year median
Notes: ‘B-‘ issuer downgrade percentages from 2001 to 2022 are based on S&P’s one-year rating transition analysis on a static portfolio. S&P’s analysis excludes speculative-grade corporates in financial and insurance services. 2023 YTD ‘B-‘ issuer transition data is based on the Morningstar leveraged loan index components as of 12.30.2022. As of May 26, 2023, 27 issuers originally rated ‘B-‘ in the index were lowered to “CCC’ and an additional two ‘B-‘ issuers were lowered to ‘D’. Data
Source: S&P Global Ratings CreditPro, Pitchbook LCD, Santander US Capital Markets LLC.
The situation is worrisome for junior tranche CLOs, which may be vulnerable to the current pace of ‘B-‘ issuer downgrades. Once a deal exceeds its allowable exposure to ‘CCC’ assets, overcollateralization tests begin penalizing ‘CCC’ balances above the limit along with defaulted loans and any trading losses. As a result, these CLOs continue to experience significant spread dispersion in the secondary market, reflecting growing investor concern.
A considerable number of outstanding broadly syndicated loan (BSL) CLOs face potential risks. Out of the 1,635 active BSL CLOs with a 7.5% threshold for ‘CCC+ or lower’ assets, 239 CLOs, or 14.6%, already have ‘CCC’ asset exposure exceeding the threshold. The median ‘CCC+ or lower’ asset exposure across these CLOs stands at 5.23% as of May 30, 2023, leaving an average cushion of 2.27% to the 7.5% threshold. However, the persistently high ‘B-‘ downgrade pace increases the vulnerability of these CLOs and adds further uncertainty to their performance.
Most downgrades have come from loans below ‘B-‘
Examining issuer downgrades in the leveraged loan index so far this year, lower-rated issuers appear to have been hit harder compared to their better-rated peers. On average, 10% of ‘B+/B/B-‘ issuers in the leveraged loan index experienced downgrades since the end of 2022, double the percentage observed among better-rated ‘BB+/BB/BB-‘ issuers (Exhibit 2). However, a significant share of loans across rating categories has been removed from the index for various reasons. A few loans with better ratings left the loan index after refinancing to a new loan with extended maturity, while some loans with weak ratings were exchanged for new debt in the debt restructuring process. The removal of weaker loans may understate the credit stress across all loan rating categories. These figures nevertheless underscore the challenges faced by lower-rated entities in maintaining creditworthiness.
Exhibit 2: Issuers with weak ratings experienced higher downgrade activity
Notes: Data are based on Morningstar Leveraged Loan Index components as of 12.30.2022. The issuer rating percentage in the index represents the number of loan facilities from issuers in each rating category as a percentage of the total number of loan facilities in the index. For example, ‘B-‘ issuers had 372 loan facilities or 24.7% of the total 1509 facilities in the index as of 12.31.2022.
Source: Pitchbook LCD, Santander US Capital Markets LLC.
Defaults in the leveraged loan market have mainly been contributed by “CCC-” or lower issuers. Since the end of 2022, 10% of “CCC-” issuers defaulted, while 18% of “CC/C” issuers followed the same path. Still, the number of loan facilities represented by “CCC-” or lower issuers remains a relatively small part of the index.
Risk in junior tranches, opportunity in senior
The risk of ‘B-‘ downgrades has led to wide dispersion in secondary market spreads on junior tranches.
While some will take the brunt of ‘B-‘ downgrades, senior or mezzanine tranches, on the other hand, may benefit from the situation. In the case of performance test breaches, CLOs’ structure diverts cash flow to pay down the most senior bond. The fast paydown of a senior bond will improve the credit support to all remaining bonds in a CLO structure, and potentially lead to a rating agency upgrade or spread tightening. A handful CLOs with ‘CCC’ assets over the 7.5% threshold have already senior junior class downgrades and senior class upgrades (Exhibit 3).
Exhibit 3: Downgrades and upgrades in CLOs exceeding 7.5% ‘CCC+ or lower’ exposure
Source: INTEX, Santander US Capital Markets LLC
This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.
Important Disclaimers
Copyright © 2025 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.
In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.
The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.
In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.
Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.
Important disclaimers for clients in the EU and UK
This publication has been prepared by Trading Desk Strategists within the Sales and Trading functions of Santander US Capital Markets LLC (“SanCap”), the US registered broker-dealer of Santander Corporate & Investment Banking. This communication is distributed in the EEA by Banco Santander S.A., a credit institution registered in Spain and authorised and regulated by the Bank of Spain and the CNMV. Any EEA recipient of this communication that would like to affect any transaction in any security or issuer discussed herein should do so with Banco Santander S.A. or any of its affiliates (together “Santander”). This communication has been distributed in the UK by Banco Santander, S.A.’s London branch, authorised by the Bank of Spain and subject to regulatory oversight on certain matters by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).
The publication is intended for exclusive use for Professional Clients and Eligible Counterparties as defined by MiFID II and is not intended for use by retail customers or for any persons or entities in any jurisdictions or country where such distribution or use would be contrary to local law or regulation.
This material is not a product of Santander´s Research Team and does not constitute independent investment research. This is a marketing communication and may contain ¨investment recommendations¨ as defined by the Market Abuse Regulation 596/2014 ("MAR"). This publication has not been prepared in accordance with legal requirements designed to promote the independence of research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The author, date and time of the production of this publication are as indicated herein.
This publication does not constitute investment advice and may not be relied upon to form an investment decision, nor should it be construed as any offer to sell or issue or invitation to purchase, acquire or subscribe for any instruments referred herein. The publication has been prepared in good faith and based on information Santander considers reliable as of the date of publication, but Santander does not guarantee or represent, express or implied, that such information is accurate or complete. All estimates, forecasts and opinions are current as at the date of this publication and are subject to change without notice. Unless otherwise indicated, Santander does not intend to update this publication. The views and commentary in this publication may not be objective or independent of the interests of the Trading and Sales functions of Santander, who may be active participants in the markets, investments or strategies referred to herein and/or may receive compensation from investment banking and non-investment banking services from entities mentioned herein. Santander may trade as principal, make a market or hold positions in instruments (or related derivatives) and/or hold financial interest in entities discussed herein. Santander may provide market commentary or trading strategies to other clients or engage in transactions which may differ from views expressed herein. Santander may have acted upon the contents of this publication prior to you having received it.
This publication is intended for the exclusive use of the recipient and must not be reproduced, redistributed or transmitted, in whole or in part, without Santander’s consent. The recipient agrees to keep confidential at all times information contained herein.
