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U.S. Middle Market CLO Test Failures Rise Amid Coronavirus Pressures, Fitch

August 04, 2020, 08:55 AM
Filed Under: Industry News

The continued deterioration in credit quality of issuers due to the coronavirus pandemic resulted in a large number of U.S. middle market (MM) CLOs failing a variety of tests for the first time in 2Q20, according to Fitch Ratings' latest U.S. MM CLO Snapshot. Twenty-three of the 58 MM CLOs covered in the report failed at least one collateral quality test (CQT) this quarter, compared to seven last quarter.

The CQT with the most failures was the minimum Fitch weighted average recovery rate (WARR) test. In addition to CQTs, 20 MM CLOs are failing at least one 'CCC' concentration limitation compared to only three deals in 1Q20. Over 50% of MM CLOs included in this report are failing at least one CQT or 'CCC' test.

The overall level of defaulted issuers ticked up but still remained historically low at 1.6% across all Fitch rated MM CLOs compared to 0.9% last quarter. In the early months of lockdowns in the U.S. many obligors were able to drawdown revolvers or defer a portion of their scheduled interest payments to obtain additional liquidity.

CLOs reported a notable increase in the number of issuers deferring a portion of their interest payments. These issuers are classified as permitted deferrable obligations. In order to meet this classification, the issuer must pay a portion of their original coupon in cash (typically LIBOR + 100 bps). While there is a test limiting the percentage of permitted deferrable obligations in MM CLOs, failing this test does not result in overcollateralization test haircuts. There were 17 MM CLOs breaching this test at the end of the quarter.

While reported defaults have remained low to date, the impact of the coronavirus pandemic continues to evolve. In addition, middle market issuers may be restructured without being flagged as defaults in CLOs. Some managers may choose to substitute credit risk loans out and restructure these loans outside of CLOs, providing an offset to traditionally illiquid nature of these assets. Therefore, reported default rates in MM CLOs may not capture a full extent of distress and the size of deferrable obligations provides additional insight.

The weighted average spread (WAS) test was the only test that benefitted from the lower interest rate environment. Due to the drop in LIBOR, many MM CLOs are receiving a pick-up in spread from LIBOR floors in place on the underlying loans. The increase in reported WAS can differ across MM CLOs and depends on a few factors including the percentage of the portfolio with LIBOR floors as well as the level of the LIBOR floor. A 1% LIBOR floor was the most common across issuers held in MM CLOs. Meanwhile, most CLOs floor the variable rate for their liabilities at zero. A comparison of LIBOR floors across managers can be found in the report.

The report is accompanied by the MM CLO Tracker, which provides in Excel form current and historical deal-specific performance metrics.

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