Stable CLO Averages Hide Junior Cushions Below 1%

What's New

Average middle market CLO metrics look steady, while the weakest deals have nearly run out of junior cushion. S&P Global Ratings found several weaker transactions now hold less than 1% of junior overcollateralization cushion. Some carry defaulted-asset exposure as high as 5%. Across the full index, the average junior cushion slipped only modestly over the year. Investors in junior and equity tranches should underwrite each deal's starting cushion and CCC exposure, since the index average will not flag the risk.

Why It Matters

The split follows tranche structure. Deals in the weaker cohort were more likely to have speculative-grade junior tranches, which start with thinner cushions. They also began the year with more CCC exposure and weaker average ratings. Buyers who chose those tranches for extra spread took on structural risk that turned a few defaults into large cushion losses. A handful of deals lost more than 2% of junior cushion in a single month. One or two new defaults caused each drop.

By The Numbers

• 2.74%: average decline in junior O/C cushion across the weaker cohort over the past year.

• 1.5%: average increase in default exposure for that same cohort.

• 347: U.S. middle market CLOs rated by S&P as of mid-September. The count stood at 307 at the start of the year.

• 0.57%: average default exposure across the reinvesting index. A year earlier it was 0.17%.

Zoom In

Ranked by cushion change, the bottom fifth of deals shows the full path. A year ago, junior cushion in this cohort averaged 5.66%. It now averages 2.92%. Nonperforming assets reached 1.64% of portfolios. They started the period at 0.15%. Par balances slipped below target, to 99.15%. CCC exposure in this group stands at 12.69%. The stronger cohort carries 7.74%. The weaker deals entered the year holding more risk, and defaults found it.

The Wrap

Middle market CLO risk concentrates in deals that started thin and drew a few bad credits. The pattern persists if defaults keep landing on concentrated positions. It eases if credit estimates on the stronger deals refresh without downgrades. Until then, S&P treats those stale estimates as CCC-, which lifts their risk scores. S&P's next quarterly slide deck, due in October, will show whether the gap between the cohorts widens.