CLO global defaults rose in 2021, inching toward the market's long-term average, while CLO tranche upgrades rose to the highest level in four years, according to S&P Global Ratings' annual study on defaults and ratings changes released this week.
CLOs are by far the largest investor segment in the $1.45 trillion U.S. leveraged loan asset class.
CLO defaults rose to 0.08% in 2021, from 0.02% in 2020, approaching the market's long-term average of 0.09%, according to the report, titled "2021 Annual Global Leveraged Loan CLO Default and Rating Transition Study." The increase included the first-ever tranche defaults for post-crisis CLOs tracked by the ratings agency.
Each the defaulted tranches were rated CCC+ or lower to start the year, and none were originally rated higher than BB.
S&P Global Ratings stated the increase stemmed from the weakened credit quality of loans in 2020, a factor that emerged subsequently in CLO portfolios the following year.
"CLO tranche defaults tend to lag corporate defaults, and the credit quality of CLOs that defaulted in 2021 had weakened during prior periods of credit stress," the report stated. "In a sign of pandemic-related credit weakening, the population of rated CLOs entered 2021 with a higher proportion of tranches rated 'B-' or lower than before the pandemic."
The average B- exposure level for CLOs in 2022 has continued to expand, reaching a record of approximately 30% of portfolio assets, according to market research report from Barclays in September.
The default count was the highest since seven defaults were recorded in 2017, the latter of which involved tranches from CLO "1.0" vehicles printed prior to the 2008 financial crisis.
"Despite these defaults, credit conditions for CLOs showed overall improvement in 2021, with many sectors well on the path to recovery from the pandemic-related credit shocks of 2020," the report stated. Among the improvements was a tranche upgrade rate of 4.1%, from 0.37% in 2020, the highest upgrade rate since 2017.
The downgrade rate was just 0.18%, involving fewer than 20 CLO tranches, according to the ratings agency. The downgrades only involved US CLOs, and only two tranches were downgraded from investment grade to speculative grade.
As a result, CLO upgrades outnumbered downgrades for the 10th time in 11 years. S&P Global Ratings noted that the pace of CLO upgrades has slowed in recent years. But that stems from the rise in refinancings and resets that stave off senior-note amortization that serves as a principal driver of upgrades, according to the report.