On 13 May 2020, the European Securities and Markets Authority (ESMA) published a thematic report on collateralised loan obligations (CLOs) credit ratings in the EU.

The report provides an overview of CLO rating practices and identifies the main supervisory concerns, and medium-term risks, in this asset class which include credit rating agencies’ (CRAs) internal organisation, their interactions with CLO issuers, operational risks, commercial influence on the rating process and the need for proper analysis of CLOs.

ESMA’s report is based on information collected until March 2020. ESMA reports that it was too early to assess the aggregated consequences of the COVID-19 outbreak since it will depend on the length of the pandemic and on the effects of the associated government interventions. ESMA highlights certain risks identified as particularly relevant for the medium term. CLO ratings can be sensitive to methodological approaches and to the assumptions on which credit ratings are based. In this regard, the future developments regarding the COVID-19 pandemic will be an important test for CLO methodologies, notably by testing: (i) the approaches and the assumptions for the modelling of default correlation among the pool of underlying loans; and (ii) the sensitivity of CLO credit ratings to how default and recovery rates are calibrated.

ESMA states that it expects CRAs to continue to perform regular stress-testing simulations and to provide market participants with granular information on the sensitivity of CLO credit ratings to key economic variables. Reverse stress-tests could also provide relevant information to market participants by showing what kind of scenarios and changes in the key parameters could lead to rating actions, including on the senior tranches.