OREANDA-NEWS. February 02, 2015. Fitch Ratings believes the introduction of minimum obligor debt issuance covenants in recent European CLOs is likely to be driven by market liquidity concerns. Based on the exposure in CLOs to date there are only small differences in the default likelihood and recovery prospects between borrowers of different size. The exposure to obligors with less than EUR200m of total debt outstanding represents about 20% of the approximately 350 European debtors on which Fitch has credit opinions.

Across the last 16 Fitch-rated transactions, nine have included covenants restricting the assets purchased by the manager according to the quantum of outstanding debt attributable to an obligor. Of the remaining six, two restrict lending according to EBIDTA levels while another restricts purchases according to how broadly syndicated an asset is.

Harvest X is typical of the type of covenant that attempts to restrict manager's exposure to obligors on the lower end of the spectrum with respect to total debt outstanding. The manager is not permitted to purchase any debt issued by obligors with total current indebtedness of less than EUR50m, increasing to 5% for debt issued by obligors with between EUR50m and EUR100m of total indebtedness, and rising to a 12.5% maximum for debtors between EUR100m and EUR200m. Similar restrictions across recently rated deals typically restrict purchases for debtors of up to EUR100m at between 5% and 7.5%, and debtors of between EUR150m and EUR200m at a maximum of 12.5%.

Fitch believes such covenants were introduced due to the perceived lack of liquidity in the loan market for such obligor debt. Syndicated loans of the size indicated by the covenants may only trade infrequently and at large spreads between asking and bid prices. This may restrict the manager's ability to sell loans in the event of credit impairment, which can subsequently restrict their ability to actively manage the portfolio. Furthermore, actively managed CLOs rely, to some extent, on market pricing. Discounted and 'excess 'CCC' assets, for example, are typically treated at their market value in over-collateralisation test calculations. These illiquid credits could therefore negatively affect the performance of CLOs.

Related to this is a concern among investors that asset managers, who recently expanded their direct lending platforms, may use CLO vehicles to fund such lending, increasing the exposure to smaller obligors with less liquid debt. Market liquidity aside, credit and recovery characteristics according to debt quantum outstanding do not fluctuate significantly across Fitch-rated European debtor universe. Within the Fitch-rated European CLO universe 6.4% of total debt is attributable to entities with an Issuer Default Rating of 'CCC' or below for obligors with less than EUR200m debt outstanding, while the equivalent figure is 6% for debtors with more than EUR200m outstanding.

Fitch's data also shows that there is only a negligible difference in the expected recovery prospects of senior secured debt between small and large obligors. While 77% of debt outstanding to obligors encumbered with less than EUR200m has Fitch recovery estimates of 60% or higher, this compares with 79% for debt attributable to obligors with more than EUR200m outstanding.

Delving further into CLO credit characteristics, in terms of diversity of income, the industries attributable to the different types of debtor tend to be reasonably similarly cyclical. While 62.1% of debt attributable to debtors of more than EUR200m can be classified as allocated to a cyclical or somewhat cyclical industry, the equivalent figure for outstanding debt of less than EUR200m is 70.4%. When exclusively considering cyclical industry exposure for debtors below and above EUR200m, the comparable figures, however, are more in line at 47.0% and 44.5% respectively.

There is a greater exposure to Europe's periphery in the shape of Italy and Spain for debt issued by obligors with less than EUR200m outstanding in the Fitch-rated European debtor universe. These two countries account for 12.7% of debt issuance for obligors with less than EUR200m outstanding but only 6.1% for debtors with more than EUR200m outstanding.

With respect to the ability to service debt from free cash flow however, 58% of debt attributable to obligors with debt outstanding of less than EUR200m have a debt service coverage ratio of below 1.0x, compared with 72.9% of obligors with debt of more than EUR200m. This would suggest that less indebted obligors are no worse placed to make their repayment obligations than their more encumbered counterparts.