S&P notes that portfolio characteristics determine the extent to which underlying collateral performance affects rating on CLOs. In a new report, it also says European economies are recovering and the default rate for leveraged loans in Western Europe has peaked and will decline throughout 2010.

"Our study of a sample of 206 European CLO transactions indicates that the 'overlap' between different portfolios is significant. This means that credit deterioration among a few key corporate obligors could affect a large number of CLO transactions," says S&P credit analyst Andrew South.

The agency notes that there is significant similarity or overlap between European CLO portfolios, with an average pair of transactions having 27% of their portfolios in common and that a number of key corporate obligors feature in almost all transactions. "A default of the most widely held obligor could have a negative effect on portfolio credit quality in nearly 90% of European CLOs," South explains. "However, in this type of scenario, we generally expect that the severity of any CLO rating effect will be mitigated because each CLO's exposure to any individual obligor is typically low. This is perhaps unsurprising, given that transaction documentation typically includes obligor concentration limits to which CLO managers must adhere."

Since S&P's last 'overlap' report in February 2009, many European economies have begun to stage tentative recoveries and it is thought that the default rate among leveraged loans in Western Europe peaked in Q309 and is likely to gradually fall throughout 2010. As a result, the agency believes European cashflow CLOs could also see slower deterioration in their credit performance.

However, S&P says the default rate among underlying corporates will still remain elevated from long-term average levels for some time. Furthermore, it says it may downgrade some European CLOs as it continues to work through the application of recently updated criteria for all CDOs backed by corporate credit risk.