European Structured Credit: SME CLO Performance Review

Morningstar DBRS published a commentary providing an update on the recent developments in the European Small and Medium-Size Enterprises (SMEs) sector and the performance of SME collateralised loan obligation transactions (SME CLOs) rated by Morningstar DBRS across different European countries.

-- With inflation receding in most countries of the European Union, central banks have remained cautious with a determined reversal of monetary policies. At this point, both floating debt and newly issued fixed debt are still only available at higher rates. This, combined with a continued tightening of lending standards by banks and other capital providers, has made access to affordable debt financing a prime concern for SMEs.

-- For the year 2023, GDP increased by only 0.4% in the EU, and expectations of low growth have carried over into this year. Below-trend GDP growth will keep pressure on profitability at a time of high operating costs for SMEs, with only gradual relief from energy prices, continuing wage growth, and lingering supply-chain pressures.

-- While loan default levels had been subdued during the pandemic because of government support measures, their phase-out and the normalisation of business activity have elicited the predicted catch-up effect and bankruptcy levels have started to rise across EU member states.

-- Despite a mediocre economic outlook and the deteriorating performance of the asset class in the short and medium term, SME CLOs rated and monitored by Morningstar DBRS have remained resilient as they typically are well diversified and exhibit low levels of borrower- or industry concentration. They also tend to deleverage quickly, which is beneficial to the build-up of additional credit enhancement. Overall, we currently see limited risk to the rated notes because of high diversification and ample cushions of credit enhancement to absorb losses.

"Overall, persisting geopolitical uncertainties, market dislocations, and a higher interest rate environment coupled with low growth across Europe will continue to weigh on SME profitability", said Stephan Rompf, Vice President of European Structured Credit at Morningstar DBRS. "We expect these headwinds to remain in the short and medium term, although there are some positive signs on the interest rate environment as the cycle of rate increases is starting to reverse (although interest rates are not likely to fall to their previous low levels). Therefore, delinquency and default levels are expected to remain elevated until some of the headwinds abate".