What is a CLO (Collateralized Loan Obligation)?
– A collateralized loan obligation (CLO) is a securitized package of many corporate loans—typically leveraged or below-investment-grade bank loans—assembled so investors can buy pieces of the cash flow. A CLO manager actively runs the loan pool, and the vehicle issues multiple layers of securities called tranches that have different priority in payments and different risk/return profiles.
Key terms (defined)
– Tranche: a slice of the securities issued by the CLO; each tranche has a repayment priority and a coupon (interest) rate.
– Equity tranche: the most junior piece that gets residual cash flows after all debt coupons and expenses are paid; typically unrated and highest-risk/return.
– Debt tranche (or mezzanine tranche): rated securities that pay fixed or floating coupons and have higher priority than equity.
– Special purpose vehicle (SPV): a bankruptcy-remote legal entity that holds the loans and issues the CLO securities.
– Waterfall: the order in which cash from the loan pool is applied to pay fees, interest, principal and then equity.
– Reinvestment period: an initial phase (often several years) when the manager can buy and sell loans to maintain the portfolio.
How a CLO is structured and how it works (concise overview)
1. Origin: A CLO sponsor/manager sets up a special purpose vehicle (SPV) to buy a diversified portfolio of leveraged loans (often 100–300 loans).
2. Capital structure: The SPV finances purchases by issuing multiple tranches of debt and one equity tranche. Senior tranches have higher payment priority and lower coupons; junior tranches and equity absorb
junior tranches and equity absorb first losses and therefore offer higher expected returns (and higher volatility) to compensate.
Cash-flow mechanics — the waterfall (concise)
– Collections: interest and principal collected from the loan pool flow into the SPV.
– Fees first: manager fees and trustee/admin fees are paid before noteholders.
– Interest on rated tranches: coupons on debt tranches are paid next according to seniority
– Principal on rated tranches: after interest on rated tranches is paid, scheduled principal (amortization) on those tranches is paid according to contract rules. If there is insufficient cash to pay full scheduled principal, seniority again determines who is paid first; typically senior tranches are protected from principal shortfalls longer than junior tranches.
– Tests and diversion (OC and IC): two ongoing covenants commonly govern whether cash is paid to equity or must be diverted to repay debt:
– Interest coverage (IC) test: compares available interest cash (after fees) to the interest due on rated notes. If the ratio falls below a contract hurdle (e.g., 1.25x), cash that would have flowed to equity or junior notes may be diverted to pay down senior principal until the test is restored.
– Overcollateralization (OC) test: compares the value (or par) of the loan collateral to the outstanding balance of rated debt. If the collateral coverage is too low versus a required target, excess cash is used to pay down debt (typically the most junior rated tranche) rather than to equity.
When a test fails, the waterfall “flips” — payments that would have gone to equity/junior notes are redirected to restore the tests.
– Reinvestment period vs. amortization period: many CLOs have a reinvestment (or “ramp”) period
…or an amortization period. Continue:
Reinvestment period vs. amortization period — mechanics and consequences
– Reinvestment period: a defined early phase (commonly 3–5 years) when the CLO manager can buy and sell loans and use principal repayments to purchase new loans. The goal is to maintain portfolio yield and credit quality while senior tranches remain outstanding. During this phase, principal cash flows are typically routed first to rebuild the collateral pool rather than to repay rated notes or equity holders.
– Amortization period: the phase after reinvestment ends (or after certain triggers) when principal repayments are used primarily to pay down the CLO’s debt tranches according to the waterfall. Managers have limited ability to reinvest; the portfolio is de-risked over time by systematically reducing rated debt balances.
– What can cause an early switch (early amortization)? Failure of coverage tests (interest coverage or overcollateralization), breaches of concentration limits, or other structural triggers. When a trigger occurs, the waterfall “flips” so that available cash goes to retire debt (usually beginning with the most junior rated tranche) until the tests are restored.
Worked numeric example: how an OC test failure redirects cash
Assumptions
– Par value of collateral loans: $1,000m
– Outstanding rated debt (senior + mezz): $750m
– Required OC ratio (hurdle): 1.25x
OC ratio = collateral par / rated debt par = 1,000 / 750 = 1.333x (initially passing)
Now suppose collateral value falls by $150m (market losses or principal paydown to equity) so collateral par = $850m.
New OC ratio = 850 / 750 = 1.133x, which is below the 1.25x hurdle.
Consequence: excess cash that otherwise would go to equity or junior notes is redirected to pay down rated debt principal until OC ratio restores. To find required rated debt level to restore OC = required debt = collateral par / hurdle = 850 / 1.25 = 680m. So the CLO must reduce rated debt from 750m to 680m = 70m of principal paydown prioritized over equity distributions.
Key metrics and formulas (define on first use)
– Overcollateralization (OC) ratio = par value of collateral / outstanding balance of rated debt. (Higher = more cushion.)
– Interest coverage (IC) ratio = coupon/interest income from collateral / interest due on rated notes. (Often expressed as (earnings available for interest) / (interest due).)
– Weighted average coupon (WAC) = sum(coupon_i * weight_i), weights by par. Gives average coupon of portfolio.
– Weighted average life (WAL) = average time until principal repayment, weighted by scheduled or expected principal payments.
– Weighted average loan age (WALA) = average time elapsed since each loan was funded. Helps assess seasoning.
Simple WAC calculation example
Three loans: A ($400m at 6%), B ($300m at 5%), C ($300m at 8%)
WAC = (400*6% + 300*5% + 300*8%) / (400+300+300)
WAC = (24 + 15 + 24) / 1,000 = 63 / 1,000 = 6.3%
What investors should check — a practical due-diligence checklist
1. Manager track record: length of firm history, past CLOs, default/recovery performance.
2. Structural features: length of reinvestment period, amortization triggers, OC/IC hurdles, priority of payments.
3. Collateral quality: average rating/grade, industry concentration limits, top obligor limits, WAC and WAL.
4. Tranche specifics: tranche rank, coupon type (fixed vs. floating), maturity, call features, legal final maturity.
5. Fees and expenses: management fee, incentive/priority fees, placement and trustee fees.
6. Transparency and reporting: frequency of portfolio reporting, loan lists availability, trustee reports.
7. Liquidity and secondary market: typical bid/offer spreads for the tranche class, historical trading activity.
8. Regulatory/structural compliance: risk-retention method (e.g., 5% retention), relevant tax treatment.
9. Ratings and research: recent rating agency reports and assumptions; understand base-case vs. stress-case scenarios.
10. Scenario testing: model impact of default rates, recoveries, prepayment speeds, and interest-rate shifts.
Principal risks (concise)
– Credit risk: losses from borrower defaults and recovery rates lower than assumed.
– Structural risk: complex waterfalls and triggers can redirect cash, lowering expected returns for equity or junior investors.
– Manager risk: active portfolio management decisions affect realized performance.
– Market and liquidity risk: secondary markets for CLO tranches can be thin; secondary prices may move with macro conditions.
– Interest-rate and spread risk: mismatch between loan coupons and tranche coupons, or widening credit spreads, affects cash flows and market value.
– Rating agency and model risk: rating assumptions on defaults and recoveries may change, affecting tranche valuations.
– Legal and regulatory risk: tax treatment, risk-retention rules, or regulatory change can alter economics.
How to model a simple stress case (step-by-step)
1. Start with base inputs: collateral par, WAC, default rate, recovery rate, rated debt par, OC hurdle, IC hurdle, reinvestment length.
2. Calculate expected annual interest income = collateral par * WAC.
3. Subtract interest due on rated notes to get excess spread (before fees/expenses).
4. Apply an assumed default scenario: reduce collateral par by defaulted principal * (1 – recovery).
5. Recompute WAC (if defaults concentrated) and OC ratio.
6. If OC or IC falls below hurdles, model cash redirection to debt paydown and recompute cash flows to tranches and equity.
7. Repeat for multi-year horizon, applying default timing and amortization rules.
Example stress step (numeric)
– Base collateral par = $1,000m; WAC 6%; rated debt = $750m; senior interest due = 3% on 500m = $15m; mezz interest due = 5% on 250m = $12.5m; total interest due = $27.5m.
– Interest income = 1,000 * 6% = $60m. Excess spread before fees = 60 – 27.5 = 32.5m (used for fees, equity, OC restoration).
– Assume severe defaults over year = 10% of par (100m), recovery = 40% so net loss = 60m; collateral par drops to 940m. Recompute OC = 940 / 750 = 1.253x (still marginally passing a 1.25x hurdle).
– If defaults were 15% instead, net loss =