First European CLOs Fail Key Test Amid Strain of Pandemic Impact

(Bloomberg) -- Cracks have appeared in the defenses of European collateralized loan obligations for the first time since the last financial crisis as portfolios buckle under the strain of the coronavirus pandemic.

Four transactions from three managers, Alcentra, Barings and Bardin Hill, showed a breach of one or more of their so-called over-collateralization tests based on May filings, according to research data from Bank of America Corp. The tests are designed to protect those who buy the less risky portions of the portfolio.

Spokespeople for Alcentra and Bardin Hill declined to comment. A spokesperson for Barings did not immediately respond to a request for comment.

The failures amount to less than 3% of outstanding European CLOs, and are mostly focused in the junior debt tranches. Even so, the first fissures to show up in a European market worth 134 billion euros ($150 billion) will lead to scrutiny about the impact of the pandemic on the structures of vehicles that bundle up speculative-grade loans.

If they're still in breach at the next quarterly payment date, investors in the affected bonds and equity notes will miss out on interest payments and managers will forfeit some fee income -- a situation they'll be keen to avoid.

Managers “will do what they can, actively trade assets, to comply with their OC tests around the test date,” said Geoff Horton, a CLO strategist at Barclays Plc. “That's especially true if they are on the cusp of a breach and subordinated management fees are at risk.”

Read More: Europe's CLOs Get Ratings Respite Though Threat Still Looms

Managers' options include trading out of lower-rated assets. They can also book gains by selling credits that have increased in value since entering the portfolio.

Even so, those who have tripped other portfolio tests may face limits on what they can buy and sell. Those with older transactions that have moved out of their reinvestment period may also be less able to fix the damage through trading.

Similarly, managers are at the mercy of ratings firms given the potential for more asset downgrades to push tests out of compliance, or alternatively for upgrades to bring them back into line, managers said.

Drilling down

European CLOs have weathered the pandemic shock better than their U.S. counterparts, which entered the crisis with greater numbers of lower-rated assets. A rally in loan markets, which got underway in April, and a slower pace of downgrades on CLO assets, has also provided respite.

Nevertheless, European portfolios are feeling the strain of asset downgrades, especially those holding higher numbers of riskier assets at the outset.

Vehicles are restricted in the amount of triple-C rated assets they can hold at par in their portfolio, with 7.5% typically being the upper limit. Assets held above this level have to be marked at their trading price. The slew of downgrades triggered by the pandemic means that about 45% of transactions in Europe now exceed that threshold for triple-C assets, according to Bank of America research.

That in turn reduces the average value of the portfolio and can trip the asset-coverage tests, which can switch off cash-flow streams to certain investors in order to protect those who purchased safer portions of the portfolio. There is an OC test at each tranche level, and typically a breach will impact the interest on the bonds that fall below that tranche.

These initial test failures may not necessarily signal the start of a larger swathe of breaches in European CLOs. Average OC tests' cushions remain solid, and what happens next will depend on how quickly economies recover from the crisis, how many defaults materialize and the potential for more volatility that would push down loan prices.

Much could hinge on second-quarter corporate earnings, given the high number of credits held by CLOs still on negative watch for downgrade, said Horton. Equally, managers may get some more OC relief if earnings aren't as bad as some managers fear.