Fitch Ratings will apply an updated stress scenario to all CLO portfolios globally for exposure to issuers that have greater vulnerability to disruptions caused by the coronavirus pandemic, the company said. The agency applies a one-notch rating adjustment to all corporate issuer ratings in CLO portfolios based on industry and outlook, and reduces recovery rates in vulnerable industries. Any CLO note ratings showing a significant failure under the stress scenario will be placed on Rating Watch Negative (RWN), which the agency expects to resolve following rating actions on the underlying companies.

A prior sensitivity stress focused on seven specific industries vulnerable to measures enacted for social distancing, but rating actions by Fitch's corporate ratings team were not limited to these industries. Numerous corporate rating actions have been taken across various sectors in recent weeks. The updated stress scenario incorporates guidance from Fitch's corporate ratings team based on its anticipated rating actions over the coming weeks.

In the updated sensitivity stress, the agency expands the scope to include issuers with loans in CLOs from the automobile industry as well as all corporate issuers on Negative Outlook regardless of industry sector. This results in average default projections within portfolios of 7% for the first year and 8% for the second year for EMEA CLOs, and 7.5% and 9% for US CLOs. Fitch believes this to be broadly in line with the base scenario as published by its EMEA and US leverage finance teams (see "Europe's High-Yield Default Rates Rise as Credit Cycle Turns" and "Fitch U.S. Leveraged Loan Default Insight").

As Fitch projects default rates to increase it also expects recoveries in the eight vulnerable industries to decrease. The agency therefore applies a haircut to recovery assumptions in its updated stress scenario. The agency applies a multiplier of 0.85 to recoveries at all rating scenarios to issuers in these eight industries. This recovery haircut reflects anticipated movement in going-concern EBITDAs for the recovery analysis, increased use of the liquidation approach instead of the going-concern approach and otherwise weaker valuations in the affected sectors.

Fitch expects that the expanded scope of its sensitivity stress test will result in CLO exposure to issuers affected by notching adjustments will range from 15% to about 35%, compared with 15% to 20% in its prior stress test. The recovery rate multiplier is expected to lower base-case recovery prospects to between 1.5% and 4.2% for CLO portfolios.

We expect that more CLO note ratings to be placed on RWN, with the greatest exposure at the sub-investment-grade rating levels. For EMEA CLOs, the agency expects that the majority of sub-investment-grade ratings will be placed on RWN. Most investment-grade ratings are expected to be resilient under the expanded sensitivity stress, but some may be placed on Negative Outlook if the sensitivity stress shows a small shortfall.

Fitch will test the entirety of CLO note ratings using this sensitivity approach and we expect to publish the results of the review over the next two weeks. The analysis will be based on the stable interest rate scenario but include the front-, mid- and back-loaded default timing scenarios as outlined in Fitch's criteria.