Negative Euribor levels pose risks to European CLOs that do not have sufficient mitigants in place to deal with negative interest rates through asset- or liability-level interest rate floors, says Moody's Investors Service.

"European CLOs, especially those without enough assets with interest rate floors, will receive reduced excess spread and therefore have less credit enhancement because of the negative turn Euribor took last year," says Javier Hevia Portocarrero, a Vice President and Senior Analyst at Moody's.

"US CLOs are not as susceptible to negative interest rates because, even if Libor turns negative, the excess spread impact would be less than that on European CLOs, because US deals have a higher portion of collateral with interest rate floors," says Aniket Deshpande, an Assistant Vice President and Analyst at Moody's.

Moody's report, entitled "Negative Interest Rates Hurt Some European CLOs, Have Little Impact on US CLOs," is available on www.moodys.com. The rating agency's report does not constitute a rating action.

The three-month and six-month Euribor, the most commonly used reference indices for floating-rate assets and liabilities in European collateralised loan obligations (CLOs), have been below zero for several months. In the absence of these floors, negative Euribor reduces the interest income from the CLO's assets and, in turn, the excess spread that is meant to offset credit deterioration in the event of coverage test failures. The actual impact on excess spread will likely depend on percentage of assets with floor, deal leverage level, liability floor (if any).

Moody's says some European CLO 1.0 tranches are at greater risk of not receiving a coupon because they do not have zero floors on their liabilities and have lower liability spreads than CLO 2.0 notes. Of the 489 European CLO 1.0 tranches Moody's rates, 85 have a spread over Euribor of 30bps or lower, and could receive zero payment if Euribor dips to -0.30%, the lowest point in Moody's forward-Euribor projections.

Many European CLOs hedge the currency risk of non-euro-denominated assets in their portfolios through perfect asset swaps. These swaps, depending on the netting provisions, will reduce CLOs' excess spread because CLOs receive swap payments based on Euribor and make swap payments based on other reference indices. Some of the impact of negative rates is mitigated by the high spreads on leveraged loans of typically 300+ basis points. However, certain swap provisions could magnify the negative impact of negative interest rates on excess spread

Moody's says the impact on excess spread will be lower on US CLOs than on European CLOs, even if Libor were to turn negative, because US CLOs have a higher portion of collateral with interest rate floors. The median US CLO 2.0 and 1.0 portfolios have interest rate floors for 96% and 68% of their assets, respectively, compared with 50% for European 2.0 and 30% for European 1.0 portfolios. Furthermore, some recent US CLOs are structured with zero floors on their CLO notes, which protects CLO note holders against reduced payments in the event Libor turns negative.