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.
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
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