United States: What Are The Economic And Practical Effects Of COVID-19 On The European CLO Market?

The coronavirus pandemic and the measures put in place to restrict its spread have disrupted economies and slowed economic growth, affecting the European CLO market from an economic perspective. The loan and bond markets from which the pools of underlying collateral for CLO transactions are drawn are experiencing price volatility and substantial downward price adjustments). In addition, we are seeing waves of rating agency actions in respect of the same collateral. Rating agency actions are also being seen on CLO liabilities.

The coronavirus outbreak has adversely impacted the global supply chain, market and economies, causing significant uncertainty in both domestic and global financial markets and volatility and disruption in the capital markets. Businesses across the world have suffered unexpected decreases in income, adversely affecting their ability to make payments or maintain financial covenants under their debt facilities.

Underlying assets may be considered for the purposes of CLOs to be 'defaulted', 'deferring' or 'discounted' as a result (as further detailed below).

Downgrades and negative watch actions have affected and continue to affect the loan market as a result of the coronavirus pandemic. Research estimates that S&P Global and Moody's have downgraded 21% and 23% of the S&P/LSTA Leveraged Loan Index as of 1 May.

Each asset forming part of a CLO's portfolio will be rated by a rating agency, and when there are negative rating actions in respect of assets in the portfolio this can affect the ratings applicable to CLO liabilities and the cash flows thereunder (after the application of certain tests and haircuts as further detailed below). In the current environment, rating agencies have been applying additional stress testing and loss assumptions in respect of particular sectors and have been adjusting methodologies to accommodate for recent events. This has led to European CLO liabilities (particularly those rated 'B' and 'BB') being put on negative watch in recent weeks, with a potential of downgrades in the future. There have been a significant number of CLO liability downgrades in the US, in addition to negative watch changes.

CLO transactions are structured on the basis of overcollateralisation. The value of the underlying collateral compared with the issuer's liabilities is tested throughout the life of the deal. If minimum overcollateralisation (or 'par value') levels are not met, issuers are obliged to prepay more senior classes of notes until the required levels are achieved.

When testing levels of overcollateralisation, the value attributed to each underlying asset is dependent on its classification for the purposes of the CLO. In the current environment, two of the biggest issues affecting overcollateralisation ratios are the number of defaulted assets and the number of excess 'CCC' assets. An asset which is classified as defaulted will be carried at the lower of its market value and its rating agency assigned recovery rate. Further, although transactions will usually permit a bucket of 7.5% of the portfolio to be rated 'CCC' or below, any excess over such 7.5% bucket will be carried at market value for the purposes of the par value testing. Most transactions maintain an overcollateralisation cushion to withstand movements in collateral value in the normal course, however, with anticipated increases in defaults and more assets being subject to rating downgrades, many transactions are seeing erosion of their overcollateralisation cushion.

The overcollateralisation cushion can also suffer erosion where underlying obligors take action to defer payment of interest such that the relevant obligations become 'deferring obligations' for the purposes of the CLO and are haircut in a similar manner to defaulted obligations.

Downward secondary market price movement has also increased a potential for asset purchases to be classified as 'discounted' for CLO purposes, forcing CLO managers to haircut such assets to market value, rather than being able to carry them at par.

Underlying obligations may benefit from the ability to elect to defer payments or even switch to less frequent payments. CLO 2.0 transactions include a trigger so that if a sufficient portion of the portfolio (usually around 20%) switches from quarterly payments to less than quarterly, then the CLO liabilities will switch to semi-annual payments.

CCC migration may lead to portfolio profile tests in respect of 'CCC' rated assets (usually limited to 7.5% of the portfolio) being breached. Although the breach of a portfolio profile test would not be an event of default under a CLO transaction, such a breach may restrict reinvestment until cured (or at least to the extent any reinvestment would not 'maintain or improve' the test position). This could ultimately limit liquidity in the loan market provided by reinvesting CLOs.

With increased negative rating actions on underlying portfolios, CLO transactions are seeing weighted average rating factor tests moving away from compliance. Although the breach of such a collateral quality test would not be an event of default under a CLO transaction, it may restrict reinvestment until cured (or at least to the extent any reinvestment would not 'maintain or improve' the test position). This could also limit liquidity in the loan market provided by reinvesting CLOs.

CLO transactions in their pre-effective date/ramp-up period may also be affected by the coronavirus pandemic. Rating actions (including the potential downgrade of ratings applicable to the underlying portfolio) taken between the issue date and the effective date could result in: (a) a downgrade of one of more classes of notes from their initial ratings and (b) certain collateral quality tests and portfolio profile tests not being satisfied as at the effective date. Either of these would result in the prepayment of the notes to the extent required to cure the effective date rating event.

In an attempt to avoid the forced liquidations and fire sales of the 2007/8 financial crisis, European CLO 2.0 warehouse portfolios are not typically marked to market in the traditional sense. However, a number may include mark to market triggers causing a drawstop based on a decline in the market value of the portfolio. Managers have seen such warehouses become static due to this feature pending either recovery of portfolio values or a wind down to maturity, and warehouse providers are monitoring their exposure to warehouses closely.

The coronavirus pandemic has introduced uncertainty and volatility into the European CLO market. With this uncertainty, the European CLO market slowed considerably following a positive start to 2020. New issuance for the first four months of 2020 was down approximately 30% in the same period last year.

However, at the end of April, the European CLO new-issue market re-opened with three deals pricing in a week. Although pricing is wider than that from early March, there is hope that these deals will help to encourage more deals to the market. These deals feature low-levered and closely held (as opposed to broadly syndicated) capital structures, with shorter non-call periods and reinvestment periods in pre-coronavirus issuances.

Regulation (EU) 2017/2402 of the European Parliament and of the Council (the Securitisation Regulation) applies to 'securitisations' (which term includes CLOs and most CLO warehouses) issued on and after 1 January 2019. The Securitisation Regulation sets out extensive transparency and reporting requirements applicable at different stages of securitisations: (i) before pricing, (ii) quarterly (or monthly for ABCP) and (iii) without delay. The effects of coronavirus described above may trigger certain reporting obligations.

Articles 7(1)(f) and (g) of the Securitisation Regulation impose reporting requirements in respect of inside information and significant events respectively. Such reporting requirements may be triggered as a result of the effects of coronavirus on the European 

Inside information-applies to transactions where Regulation (EU) No. 596/2014 on insider dealing and market manipulation (MAR) applies (including transactions listed on Euronext Dublin (formerly known as GEM)). 

Significant events-applies to all securitisations.

Inside information and significant events are required to be reported 'without delay'. There has been no guidance as to the meaning of 'without delay' but the market view is that reporting should be done on a timely basis. For example, waiting until the next periodic report to report a significant event or inside information would not be appropriate if to do so would cause such report to be delayed.

Article 7 of the Securitisation Regulation requires that the originator, sponsor and securitisation special purpose entity (ie the issuer) of a securitisation make the specified information available. Although the originator, sponsor and issuer of a securitisation may designate among themselves one entity to fulfil the reporting requirements, such a designation would not release the other entities from their obligations.

The Securitisation Regulation requires that information to be reported pursuant to Article 7 is made available to investors, national regulators (of the originator, sponsor and issuer) and potential investors (upon request therefor). In addition, national regulators may impose further requirements (for example for UK regulated CLO managers, the Financial Conduct Authority or the Prudential Regulatory Authority also require notification of inside information and significant event reports).

The Securitisation Regulation describes inside information relating to a securitisation that the relevant originator, sponsor or issuer is obliged to make public in accordance with Article 17 of MAR. The Securitisation Regulation also sets out a non-exhaustive list of events which would be considered as significant events, this includes:

In the context of European CLOs and warehouses and the current coronavirus pandemic, examples of events which originators, sponsors and issuers of securitisations should consider reporting may include:

However, the decision as to which events may be reportable will need to be made by the relevant transaction parties, taking into consideration the effect of such events on the securitisation. The above list is not exhaustive , and the fines for non-compliance due to negligence or wilful breach are significant. As such, it would be prudent to err on the side of caution when considering whether or not to report.

Most European CLO warehouses and CLO issuances would be considered as private transactions for the purposes of the transparency requirements. As such, there is no prescribed form for the reports required under Articles 7(1)(f) and (g) of the Securitisation Regulation. A report should likely include a description of the relevant event and, if appropriate, the consequences thereof. Where, in respect of a European CLO transaction, periodic reports are already made available on a website, it is expected that the Securitisation Regulation reports will also be made available to relevant parties on such website. In respect of European CLO warehouses, it is expected that such reports will be made available to the relevant parties by email.