France’s rating downgrade by S&P will have unwelcome consequences for many European CLO managers.
Referring to uncertainty about the state of France’s public finances, the rating agency shunted its unsolicited foreign and local currency long-term and short-term sovereign credit ratings to A+/A-1 from AA-/A-1+.
In that S&P expects French national debt to reach 121% of GDP in 2028, its concerns about the French government's lack of fiscal responsibility are well-founded.
But the downgrade will have caused a number of CLO managers to review their portfolios with some urgency.
Most CLOs are set up so that managers breach their portfolio profile tests (PPTs) if more than 20% of their portfolios consist of loans with obligors in countries rated below AA-.
French loans have now been tipped unceremoniously into this 20% bucket along with those from countries such as Italy, Spain, Portugal and Poland.
CLOs that were previously well within the 20% threshold may now have raced past it, given the sheer size of the French leveraged loan market. Figures from White & Case show that French leveraged loan issuance reached €44.8bn in 2024.
At least a quarter of European CLOs have more than 20% exposure to France, according to Accunia Credit Management. Problems stemming from the French downgrade are therefore likely to be widespread.
Rule change
As CLO covenants stand, managers that have exceeded the threshold have few options but to sell loans from countries rated below AA- to try to improve their PPTs. Managers will also be more limited as to the volume of loans they can purchase from issuers in these countries.
Faced with constraining rules as to how they can trade, managers may simply appeal to S&P for these rules to be changed.
The size of the sub-AA- bucket could be increased, or it could simply be transformed into a sub-A- bucket. Either option would restore some trading flexibility to CLOs.
This could be viewed as a case of players asking the referee to change the rules as soon as those rules no longer suit them. But pragmatism dictates that there are few alternatives.
Loans from most of Europe’s major economies are now within the 20% bucket. If the UK were to be downgraded from AA/A-1+, Germany would stand almost alone above the threshold with its triple-A rating. A source noted that UK-domiciled loans make up about 10%-15% of most European CLOs.
A UK downgrade is plausible given the depth of its fiscal hole — public sector net debt was at 95.3% of GDP at the end of September, according to the House of Commons.
In simple terms, European CLOs cannot depend on Germany for a vast proportion of the leveraged loans that make up their portfolios.
The rules concerning country risk are largely designed to protect CLO investors from large scale volatility in the way a particular country is run, which can have an impact on the economy and on the quality of individual credits.
It is true that S&P’s rating report on France made reference to the “most severe political instability since the founding of the Fifth Republic in 1958”. Nonetheless, France remains above investment grade and seems unlikely to descend into total economic disarray any time soon.
Leveraged loans are, by definition, below investment grade and investors in the CLOs that hold these loans will ordinarily price in country risk.
There are, of course, limits to how much rating agencies can feasibly adjust covenants if these covenants are to shield investors in a meaningful way.
But it could be overzealous to allow the downgrade of a sovereign that has remained investment grade to skew the entire European CLO market.