IFR 03.7.2020

74 International Financing Review March 7 2020

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CLOs face pressure on credit

downgrades

„ EUROPE Outlook downgrade of UK’s EG Group attracting most attention

CLO managers are coming under pressure as an

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

past few years due to slower economic growth,

but the pace of downgrades has accelerated in

recent months even without taking into account

the 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 pharmaceuticals group NOVACAP, Belgian

chemicals 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 managers.

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 more than

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.

ACCELERATED DOWNGRADE

Though EG Group’s corporate rating remains at

B2, its negative outlook triggered by a weaker

earnings 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.”

VIRUS TEST

An individual credit downgrade will not

immediately break the WARF test, but the

coronavirus spreading in Europe has complicated

the situation as risks build of a widespread

downgrade hike.

“We expect more negative outlooks and rating

watches negative to accompany new information

releases and management updates,” said 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.”

Prudence Ho

9 IFR Loans 2323 p 63 - 76 .indd 74 06 / 03 / 2020 19 : 19 : 51