Mark Twain is often misquoted as saying "History never repeats itself, but it often rhymes." Whoever said them, these words certainly come to mind in the current economic crisis brought about by the COVID-19 pandemic. Although the circumstances are quite different from the credit crisis of 2007-2008, CLO market participants find themselves navigating a number of the same issues that arose during that crisis. Given the incredible, and fast unfolding, events of the last couple of months, market participants have faced a gauntlet of difficult circumstances brought about by defaults and downgrades of assets within current CLO portfolios.

Interestingly, at a time when many lenders have shown admirable restraint in dealing with borrowers (including leveraged loan and SPV borrowers), so as to avoid a repeat of the mistakes made during the great financial crisis of 2007-2008, many rating agencies have interpreted their mandate in a different light. As of April 20, 2020, over one thousand CLO tranches have been put on negative watch or outlook by the three major rating agencies, and according to Creditflux, only 18% of US CLO managers have avoided negative rating action.

Because of this, many in the CLO market have had questions regarding the provisions in CLO indentures dealing with defaults and downgrades. While every transaction is different, and specific answers will depend on the fine print in the underlying documents, this OnPoint is intended to serve as a general guide and refresher as to the impact of distressed assets and debt tranches under a typical CLO indenture.