Fitch: New Covenants in European CLOs Ensure Greater Obligor Diversity

Fitch Ratings says that the inclusion in recent European CLOs of additional covenants on the largest 10 obligors is credit positive as they ensure greater portfolio diversity. The covenant should help to mitigate performance volatility, especially during stress periods.

The additional covenant appears to have been included in structures as market best practice and typically limits CLO exposure to the largest 10 obligors at 20%. This compares with 26.5% for typical European CLO.

The European leveraged loan market is still much smaller than the US market. Fitch has credit opinions on approximately 400 corporate issuers and typical CLO portfolios include between 60 to 130 corporate issuers. US CLOs in contrast are more diversified with a larger number of corporates.

When analysing European CLOs, Fitch will differentiate between CLOs that have the covenant and those that do not. On average the rating default rate (RDR) can be up to 2% lower at the 'AAA' level for CLOs that include the covenant.

However, Fitch has observed that some existing 2.0 deals have higher obligor concentrations than originally envisaged. Therefore, for CLOs that do not include measures to ensure diversity, i.e. this covenant or other mitigants, Fitch will reduce the maximum number of obligors included in the stress portfolio to be in line with the market-observed minimum number of 60 for European 2.0 CLOs. The theoretical minimum for a typical European CLO without the additional covenant is 40 obligors. As a result the 'AAA' RDR for a typical CLO without this covenant (or other diversity mitigants) could increase by up to1%.
This will not affect existing CLO ratings: because managers do not fully use the flexibility they have under the terms and conditions, the RDR for actual portfolios is typical significantly below the RDR for the corresponding stress portfolios.