Various thing about CLOs or other structured fixed income product.

Overview, terms

Collateralised loan obligations: generally between ＄300M to ＄1B in size and own loans issued by 80–300 borrowers

• CLOs are companies with very limited purpose and no staff of their own
• Special purpose vehicles (SPV, aka issuer or depositor) with a manager company
  • usually based in jurisdictions that pay no corporation tax
  • issue notes to raise fund to buy the loans in the pool
• CLO has a predetermined life span
  • a final maturity date which it will be unwound (notes issued are retired)
  • in practice, investors will get their money back long before then
• CLO has limited redemption
  • investor’s money is locked away longer and more tightly than in most funds
  • CLO can only be redeemed if its equity investors vote to wind it up
• CLOs can borrow money to increase equity return
  • debt is committed for the lifetime of the CLO, a.k.a. term funding
  • other funds’ debt can demand repayment if funds’ investment falls below a certain level, a.k.a. market value-based funding
  • debt in CLOs: note
• securitisation: backed by a pool of loans
  • loans in most securitisation are either static or replaced only then they are repaid
  • CLO manager makes decisions about which loans to buy and sell in the market
  • CLO is a hybrid between a fund and a conventional securitisation

Tranche: French word for a slice

• different tranche, different level of credit production or risk exposure
• some tranches absorb early repayments (i.e., other has more predictable cash flow)
• two waterfall may exist on loans and mortgages as it is easy to differentiate the principal repayment and interests
  • interest waterfall, principal waterfall
    • order to allocate payments: make some note more senior than others
  • corporate bonds: principal is paid in one lump sum at maturity
• Tranche warfare: upon default, different tranches have conflicting goals, e.g., foreclose on a defaulted mortgage or modify the mortgage.
  • in the past, the fiduciary can exercise their judgement for their interest. Now, no such fiduciary exists.

Overcollateralisation (OC): pooling assets of principal amount greater than the security issued

• usually by 10–20%
• e.g. MBS with principal amount issued of ＄100MM while the underlying mortgage worth ＄120MM

Indenture: Legal document governing the CLO

Loans, bonds

Bonds vs Loans

• both:
  • carry a rate of interest on principal
  • can be traded
• loans typically have security whereas bonds are usually unsecured
  • loan holders have the right to seize the assets of the company in a liquidation
  • even if the company is not liquidated, secured credit typically lose less upon default
    • i.e., loans has a higher recovery rate on average (70–80% in US) than bonds (40–50%)
• loan investors usually have more control over what a borrower can and cannot do
  • these restrictions are referred to as “covenants”
  • typically restricts the borrower from taking on more than a certain amount of leverage or limit the amount of capital expenditure
• bonds usually pay interest at a fixed rate, whereas loans usually pay a floating rate
  • floating rate in terms of a margin on top of LIBOR
• bonds usually repay all their principal at maturity (a.k.a. bullet maturity), whereas loans often amortise
  • loans most frequently found in CLOs have either bullet maturity or repay only a small portion of principal before maturity
• bonds can only be called at certain times, whereas loan borrowers can repay (or call) a loan any time without penalty
  • bond holders have call protection
• loan traded in secondary market take much longer to settle
• bonds are sold by investment bank (or arranger) to hundreds of different investors, loans are made by banks before distributing them to other investors

Type of loans:

• revolving loans: act like a bank overdraft
• term loans: borrowers received all the money at the outset
• borrowers of leveraged loan:
  • a revolver as the shortest maturity loans, and an accompanying term loan (term loan A)
    • a.k.a. “pro-rata loans”
  • equal seniority but longer maturity term loan B, C, D and so on
• revolver and term loan A are usually bought by banks, not common in CLO portfolios
• term loans B, C, D are solve to institutional investors, make up majority of most CLO portfolios
• covenant-lite (cov-lite) loans: those that lack certain covenants
  • usually includes incurrence covenants but not maintenance covenants
    • incurrence covenants: tested only when borrower takes certain actions, e.g. issuing new debt
    • maintenance covenants: tested on a regular basis, e.g. every 6 months
  • constraints, for example, debt must not rise above certain levels

Loan in CLO: usually leveraged loans a.k.a. high yield loans

• often the same companies that borrow using high yield bonds a.k.a. junk bonds
• often companies that have gone through a leveraged buyout (LBO)
• high yield companies are statistically more likely to default than investment grade borrowers
  • average annual default rate around 4–5%
  • investment grade companies estimate to <1%
• high yield company’s debt has a yield around 2.5% higher than investment grade company
• some high yield borrowers increased their debts to:
  • fund acquisitions or capital expenditure
  • buy back shares
  • gone through a downturn in business (i.e., fallen angels)

Some biggest high yield borrowers in 2013:

• First Data: US payment processing company taken private in a 2007 buyout
• Community Health Systems: publicly traded hospital operator which has grown by acquiring rivals
• Delta Air Lines: emerged from bankruptcy in 2007

In 2014, issued high yield bonds or loans

• 1347 US companies
• 357 European companies

EBITA: Earnings before interest, tax and debt amortisation

• debt amortisation = repayment of debt principal
• leverage ratio defined as debt amount divided by EBITA

Cashflow and tests

CLO note and equity:

• note investor provide leverage to equity investors
  • leverage is locked in place for several years, note investor has no right to demand additional equity or seize assets
  • free of mark-to-market constraints
• note investor are paid ahead

Loans

• valued at par (principal amount), because that’s the amount it will repay at maturity
• CLOs measure the performance of investments in terms of par value
  • par value of CLO = sum of par of each of its loans
  • buying loans below par will increase the par value of CLO: par-building
• floating rate coupons: loans are traded at par much of the time
  • below par if there is a shortage of buyer or the issuer is in trouble
  • rarely trade at more than 101% of par because issuers can prepay

Building par

• par erosion: selling asset at loss below par and buy asset at par with the proceed
• par building: buying below par
• par-building received a lot of bad publicity in the early history of CLOs
  • early 2000s, debt investors accused managers taking on unnecessary risk to boost par value
  • rating agencies encouraged market participants to introduce new rules to penalise excessive par building
  • discount purchase rules: assets bought <85% of par should be valued at its purchase price for the purpose of calculating OC ratios
    • other CLOs define discounted purchases by reference to an index, e.g. S&P/LSTA Leveraged Loan index
  • swapped discount purchase obligation: allows manager to treat a discounted asset at par if it replaces another asset which is sold for a similar price, up to a set percentage of the CLO portfolio

Cashflow

Cashflow waterfalls or priority of payments

• payment from CLO only if there is enough cash left over after more senior payment in the waterfall
• interest waterfall:
  1. tax due (conventionally), trustee’s fee, senior management fee
  2. interest payment to notes
  3. junior management fee
  4. equity
     • once equity investors have reached a predefined hurdle for their returns, manager starts to receive its performance fee
• pari passu: equal footing in seniority
  • cashflow will split equally between them
• usually interest received by CLO’s loan is to pay interest on CLO’s notes
  • test fail may use the interest proceed to pay principal on CLO notes
• principal cashflow: from loans reached maturity, amortisation, or prepayments
  • amortisation: scheduled pay-down of loans as they approach maturity
  • amortisation is uncommon in CLO loans
• principal waterfall
  1. payments to note holder that had been due in interest waterfall but were not made
  2. reinvestment if still in reinvestment period
  3. pay down principal of the CLO notes in descending order of seniority, if CLO has been called or reached maturity

Accounts of CLO:

• collection account: pays all the proceeds (principal & interest) from the collateral it owns
• payment account: fund transfer from collection account a few days ahead of each payment date
  • to make all payment under cashflow waterfall

Tests

Tests: carried out at each payment date, starting at the effective date

• CLO’s rules remain unchanged if the test passes
• if failed, rules changed to the benefit of debt investors and at the expenses of equity investors

Two types of tests:

• failure results in early pay down of some liabilities
• failure results in manager prevented from carrying out some actions (maintain-or-improve tests)

Overcollateralisation (OC) test

• pass if the relevant OC ratio for each class of notes is above its original pre-determined level
  • pass level (i.e., required ratio) are set such that the most junior OC test will fail first
  • if failed, interest proceeds cannot pay equity distributions or interest on all liabilities junior to that particular tranche
  • may start to pay down principal of most senior class of outstanding notes
    • a.k.a. diversion of interest
    • pay down improves OC ratio by reducing the denominator
  • if OC test fails, principal payments must be used to pay down debt instead of buy new assets
• par value of CLO’s collateral divided by the outstanding amount of that particular class of notes and notes senior to it
• for OC test purpose, par value of poorly performing or defaulted assets may adjusted with haircut
  • CLO will fail one of its OC tests if too many defaults
  • typically defaulted loans are worth their market value or an assumed rating agency recovery rate, whichever is lower
• post-crisis CLOs
  • a few CLOs that include single B tranche: no OC test for this class
  • combined OC test for the two most senior notes (AAA and AA)
    • no way to skip payment

Interest diversion test

• triggers earlier than any of the OC tests
• failure = distribution to equity investors are suspended
  • diverted interest to invest in new assets
  • boosts the OC ratio by increasing the numerator

Various definition of loan default

• failing to pay interest or principal on actual loan owned by the CLO
• failing to pay interest or principal on debt that is pari passu or senior to the loan owned by the CLO
• bankruptcy of the borrower
• downgrade to D or similar of the loan owned by the CLO

CCC bucket

• assets rated CCC or below (Caa1 from Moody’s or CCC+ from Fitch or S&P)
  • some deals will include ratings one notch above (B3 or B-) if rating agency put that credit rating on watch for a potential downgrade
• portfolio administrator is required each month to add up the par amount of assets in CCC bucket
• if par amount is greater than a predefined threshold (e.g. 7.5%), the portfolio is adjusted by the difference between par and market value of those assets which are in excess of the threshold

Interest coverage (IC) test

• can cause CLOs to pay back liabilities early with principal and interest proceeds
• assessed each month by calculating a ratio and compare to a predefined level
• usually available for notes from AA to BBB
• ratio = interest proceeds available at that point in the waterfall divided by interest payment due on the next debt tranche
• protect debt investors in the event of insufficient income to pay the interest

Common maintain-or-improve tests:

• weighted average rating factor (WARF) test: measure the quality of a CLO’s portfolio in rating terms
  • only Fitch and Moody’s has WARF to convert rating into a numerical score
• weighted average spread (WAS) or coupon tests: ensure CLO does not invest in too many low-yielding assets
• Moody’s diversity test: Measuring the industry diversity of a portfolio
  • Moody’s diversity score: a number to address the correlation within the portfolio
  • prevent correlation of default risk of each borrowers
• S&P industry concentration limits: S&P’s approach to measure diversity, setting limit on concentrations to any particular industry
• minimum assumed recovery rate tests: ensure CLO is not over-exposed to loans with low recovery prospects
• weighted average life test: measure the expected life (based on legal maturity) of assets to ensure the portfolio is not significantly longer than the CLO liabilities
• concentration limits: different tests to ensure they stick to promised limits for exposure to different type of investments
  • second-lien loans
  • covenant-lite loans
  • exposure to individual loan or borrower

Structure and Equity

CLO structure: 80% debt tranche, 20% equity

Tranche structure and ratings

CLO notes are almost always rated

• CLO default is an event with low probability: history has no loss
• rating agencies disclosed their methodology but not the specific mathematical rules
• Fitch and S&P: likelihood of suffering any kind of loss (first-dollar-of-loss approach)
• Moody’s: magnitude of loss during its life (expected loss)
• Rating fee: 0.07% of the size of the tranche upfront
  • higher when there are shadow ratings

Rating corporate bonds or loans:

• look at company’s level of indebtedness, cashflows, its access to finance, and the dynamics affecting its industry
• shadow rating (a.k.a. credit estimate): private rating on a loan that has no rating at all
  • not disclose publicly, not paid by the loan borrower but by the CLO on annual basis
  • fee for providing shadow rating is less than a full rating
  • based on more limited information provided by the CLO manager instead of the company

Rating methodology:

• Moody’s
  • CLO’s portfolio + cashflow rules → calculate for expected loss for each tranche under different scenarios
  • compare expected loss, e.g. Aaa rating needs expected loss <0.0055% for 10 yrs
  • stress factors (i.e., additional haircut) may be imposed to take account of other risks
• Fitch and S&P
  • Monte Carlo modelling under different scenarios, e.g., different levels and patterns of default, interest rate projections, timings of defaults
  • calculate how many defaults it would take for each tranche to suffer a loss
  • S&P: compare to break-even default rate for each tranche
  • Fitch: compare to target default probabilities
  • Different ratings have a number of defaults a given tranche should be able to sustain
• Rating surveillance: Rating agency to monitor rating after the deal is complete

Reports

• CLO reports are very detailed, compare to hedge funds
• Trustee reports, prepared by the portfolio administrator, is received by all classes of investors
  • number based
• monthly report: from manager, list the CLO’s current assets
  • with size, price of all purchases and sales in the month
  • details cash balances
  • reports compliance of various performance tests
• note valuation report: from manager, show how much cash the CLO has received and all payments in that period
  • at each payment date, to investors
  • shows how the CLO’s interest waterfall and principal waterfall are working in practice
  • shows how much money is left to equity
• notices: tell investors of rating change, or minor change to the terms, or invitation to vote on proposed change
• report usually lacks market value of loans that the CLO own

Refinancing and repricing

• after crisis: equity investors are easier to refinance the CLO debt
  • before: must call the CLO in its entirety and issue a whole new CLO
  • after crisis: refinance on a tranche-by-tranche basis
• refinance: to take advantage of falling spreads on certain tranches
• repricing: equity investors to reset the coupons on individual tranches at prevailing market rate
  • debt investors are required to sell their note to a new holder if not accepting repricing
  • not a standard feature in CLO market

Kinds of CLO debt:

• almost all debt is in the form of bonds
• some case of CLO liabilities issued in the form of loans
  • e.g. 2013 & 2014, a Japanese bank bought the entire AAA tranche of some CLOs, and prefer them to issue as loan
• notes are generally issued to allow investors to switch between 144A and Regulation S (Reg S)
  • US investors buy 144A, non-US investors buy Reg S
  • 144A is a private placement, the issuer is exempt from onerous market stipulations of US securities laws
    • cleared through the US DTCC (a securities depository)
    • carry a CUSIP
  • Reg S bonds cleared through either Clearstream or Euroclear, with an ISIN
  • format of the note can be changed by a clearing house

Payment

• minority of CLO notes carry a fixed rate of interest, majority are floating rate CLOs
• floating rate notes because loans are mostly floating rate instruments
• usually only the most senior tranche is AAA, but some CLOs has the second most senior tranche also in AAA
  • created by slicing from the bottom of the AAA portion
  • junior AAA to create greater subordination (i.e., larger cushion) for the senior AAA tranche
• class X tranche: to indicate a tranche which dos not form a conventional part of the capital structure
  • post-crisis: for a very short-dated tranche which sits at the top of the capital structure
  • created to provide CLO with a small cushion of extra cash during its first few weeks (when deal has to pay some one-off fees)
• a few CLO tranches include a coupon step-up feature
  • in the life, the coupon increases to a new predefined level
  • created to make it more likely to be called at the step-up date, for a greater certainty over the expected life of the investment
• combination notes: rare after crisis, but common in the market around 2005-2006
  • commonly combines a CLO equity tranche with a senior tranche (usually AAA)
  • investor receives cashflows form the two in the specified ratio
  • appeals to insurance companies: better yield and high probability of full return of principal

Equity

CLO equity holders receive distributions only if debt and other obligations are honoured

• receives the lion’s share of profits if things go well
• CLO equity is unlike corporate equity that CLO operates by pre-set rules
  • no borrowing to pay dividends
  • cannot change strategy
• prospects assessed by the default probability and recovery of the loans
• has right to sack the manager
• has right to call the deal
  • non-call period usually 2 years from closing date for deals issued between 2009 and 2014
  • right timing to call can boost equity return: equity distributions will dwindle rapidly if CLO pays down its senior debt
  • some older CLOs are uncallable because the equity is widely dispersed, making it impossible to organise a vote
  • post-crisis: most deals issued since 2009 have majority of equity tranche owned by a single institution

Majority investor = control investor

• not the controlling class
• majority equity investor will usually be heavily involved in planning the CLO
• some case, manager = majority equity investor
• majority equity investor will provide capital for the CLO during the warehouse phase

Timing and equity return

• better: deal launched when loan arbitrate is favourable (loan return is high relative to funding cost)
• better: CLOs launched ahead of a period of low defaults
• average annualised distribution of equity in first 4 years: 10% (2008 vintage) to 24% (2002, 2011 vintage) in US CLOs
• final IRR of equity may not be known for years
  • CLOs usually end up owning a few assets that are illiquid and hard to sell
  • e.g. equity received following a debt restructuring

Risk, default, and analytics

Risk of CLOs:

• historically never loss on most senior tranches
• investment grade: AAA to BBB; high yield: BB and below
• most loans in CLO portfolio: mid to high single B rating
• junior tranche of a typical CLO: BB
• CDO backed by mortgage has similar structure as CLO, but ratings turned out to be a poor guide to the riskiness following the subprime mortgage crash of 2007
• equity tranche has an annualised return as high as 30% if things go well

default rate

Constant default rate (CDR): Annualized rate of default on a pool of loans. Default rate on loans depends on: age of loan, seasonality, burnout levels, FICO, LTV, income, etc.

Loss severity: Percentage of lost principal when a loan has defaulted

Single monthly mortality rate (SMM): In case of CPR (constant prepayment rate), that the principal prepayment

Formulae:

where:

• PP = CPR Principal Prepayment, as SMM for CPR
• $P_0$ = Starting principal balance
• $P_t$ = Principal portion of scheduled loan payment (unpaid principal)
• SMM = Single monthly mortality rate (principal loss in a month)
• LS = Loss Severity
• $S$ = Loss Severity Percent

Cashflow = Scheduled payment + Prepayment + Defaults − Loss Severity − Servicing Fee

• If the pool was original owned by the originator, there will be no servicing fee
• Defaults added because they include loss severity and recovery. This assumes the recoverable part are prepayment and happen at the same time as loss.
• (Defaults − Loss Severity) = Recoverable loans

Flat rate: Interest rate calculated without considering amortisation. For example, 12% annual flat rate of ＄1200 loan for 1 year repaid monthly, the monthly principal payment is ＄100 and the monthly interest is ＄1200 × 1% = ＄12, thus the monthly payment is ＄112. This yields a effective interest rate of 144% p.a. at the last payment. Or equivalently, a 23.68% APR compounded monthly for the overall payment (calculated using XIRR).

XIRR calculation: Assume payment is \(P_j\) at time \(j\) (sign identifies the direction), \(d_j\) is the date of payment \(P_j\), and \(d_0\) is the 0th payment. XIRR finds the rate \(r\) that solves the equation:

To find XIRR by XNPV: Set \(P_0=0\) instead of principal in the above summation and find the rate r until XNPV equals to the principal.

Converting CPR, SMM, and APS:

APS = Absolute prepayment speed.

prepayment risk

Math of monthly constant prepayment rate (CPR):

where:

• CPR is the percentage probability of prepayment within a year
• \((1-\textrm{CPR})^{1/12}\) is the probability of non-prepayment in a month

which is converting an annual interest rate into equivalent monthly interest rate

In mortgage, servicing fee is based on remaining principal. Thus the servicing fee is:

where

• \(P_r\) is the remaining principal
• \(s\) is the annual rate of servicing fee

And \(P_r\) is decrease monthly by the principal paydown as scheduled and the prepayment of amount \(\textrm{CPR}_{\textrm{monthly}}\times P_r\)

Macaulay duration

Frederick Macaulay (1938), measure the term of an option-free fixed income security

Time to receive each cash flow weighted by the PV of the cash flow, the resulting weighted average time period would be more realistic measurement of term then maturity

Alternative calculation: Assume market price of bond is an approximation of sum of PV of the cashflow, then Macaulay duration should be:

modified duration

Intended as an approximation of price volatility, not time. It measures the change in value in response to change in interest rates (interest goes up will drive price go down).

Formula:

where

• macaulay = Macaulay duration, fraction in years
• \(r\) = yield per annum
• \(n\) = number of payments per year
• 1/100 = express moddur in percentage

moddur proportional to macaulay duration because bonds with longer duration have greater price volatility.

Alternatively, \(\textrm{moddur} = \frac{1}{P}\frac{dP}{dr}\) for \(P\) the price of the bond (i.e., PV of cashflow)

Effective duration: a more accurate measurement of price volatility for loans and MBS

discount margin

DM: spread over LIBOR discount curve

• expressed in basis points

DM comes from the solution to

where \(c_0\) is the initial purchase outflow, \(c_i\) and \(d_i\) are the cashflows and discount factor at time \(i\) and the forward discount factor DM satisfies

• DM of a bond priced at par is the spread on that bond
• DM is used to compare prices across bonds, as it adjusts for maturity and coupon differences

DM in terms of present value (current price):

In case of fixed rate, we express PV in yield instead of DM:

back-of-envelope calculation: price-yield-duration formula

applied when impairment or write-down is a remote risk, which change in yield is same as change in DM in %

• duration: the modified duration
• for zero coupon bonds, duration = average life
• for coupon bonds, the duration < weighted average life (WAL)
  • WAL can be an approximation for duration: \(\textrm{Duration} = \textrm{WAL} \times \textrm{adjustment}\)
  • adjustment < 1, e.g., 0.9 for AAA tranche
• change in yield/DM is absolute change: \(\Delta = \textrm{new DM} - \textrm{old DM}\)
• change in price is relative percentage: \(\Delta = \frac{\textrm{new}-\textrm{old}}{\textrm{old}}\)

other valuation metrics

WAP: weighted average price of the deal collateral

Tranche attachment point: static measure that roughly corresponds to what percentage of the collateral has to be lost before the tranche starts taking losses

Tranche detachment point: like attach, but measures how much has to be lost before the tranche is wiped out

FCDR (flat CDR break): what constant default rate needs to be assumed in order for the tranche to start taking losses; this is cashflow based in contrast to the above

DM (discount margin): constant spread over the appropriate floating rate that’s needed to discount the cashflows to recover the given price

Interest rates

1% = 100 basis point (100 bps)

APR: annual percentage rate. Simple interest rate, may be compounded in practice.

APY: annual percentage yield. Compounded interest rate, taking the number of periods in a year into account and compare the end-of-year value against the present value.

APY > APR because of compounding.

Interest rate rules

Rule of 72: time it takes to double, e.g.

• 1% rate = 72 periods
• 2% rate = (72/2)=36 periods
• etc.

Rule of 78, aka sum-of-the-digits method: assume total interest of whole period to be ＄(\(N\)) and the total period to be \(n\) months then the monthly payment $(\(P\)) on month \(k\) will include the interest portion of \(N \times k/S_n\) where \(S_n = 1+2+...+n\)

• Using rule of 78 need to find the total financial cost ＄(\(N\)) before hand
• The interest payment is front-loaded: interest payment is higher than simple interest
  • not beneficial to prepayment: there is more principal remain to be paid off

Life cycle of a CLO

ramp up: manager start to buy the loans that form the collateral for the CLO

• start the ramp-up early at times when assets are particularly hard to find
• “warehouse phase”, the period during which the manager is building the CLO portfolio before the CLO notes are sold
  • after planning, found the bank that interested to buy the entire AAA notes and the fund manager that would be interested in taking equity
  • usually 3 months after planning, and 3 months before closing
• seed capital provided by manager or control equity investor
• fund leveraged by borrowing from arranger or another bank
• warehouse lending facility provides less leverage than the CLO will have once it has closed
  • arrangers see warehouse lending as a way for CLO arranging business rather than a source of profit

going to market

• manager buying loans for the future CLO’s portfolio
• arranger organise a roadshow, taking key individuals from the management firm to meet potential investors
  • arranger will prepare pitch book (marketing document), termsheet (proposed terms of different notes), draft prospectus or offering memorandum
  • marketing process takes 2-3 weeks from launch to pricing
• arranger builds an order book for the securities
  • sell the less popular tranches
  • choose which investors should receive good allocations to popular tranches (syndication)
  • tweak the tranche structure in response to investor demand
• sources and uses: table showing what money will come into the CLO on the first day and what money will go out
  • outgoing: one-off fees including arranger fee, and note discounts
  • equity investors will demand to see it, but not routinely disclosed to note investors

pricing and closing

• pricing date: order size and prices for each security are confirmed to investors, and investors commit to buying them
  • prospectus is finalised on pricing date
  • US securities laws: final prospectus only comes into existence once it has ceased to serve its intended purpose of informing investors about what they are buying
• 1 month in future: CLO will come into effect when investors will make payment for their securities
  • closing date or settlement date
  • manager begins to earn fees and interest starts to accrue
• CLO payment: mostly each quarter, some European deals pay once every six months
  • portfolio administrator assesses the deal for compliance with its various tests on payment date, and calculates how much should pay in interest, fees, and equity distributions
  • first payment is usually a few months longer than subsequent payment periods to give the manager time to ramp up the deal
  • large first payment distribution to equity may be a good indication that ramp-up has gone well and the manager has amassed a high yielding portfolio
• effective date: the point at which the CLO is fully ramped up, and various tests start to take effect
  • US deals: 4 months after closing, longer in European CLOs
  • manager needs to get the rating agencies to confirm the rating of the notes
  • manager will declare the CLO effective, if failed to do so by the cut-off date, it may be force to paying down the CLO notes
• reinvestment period: manager is able to trade the portfolio and reinvest the proceeds of loan amortisation and repayments
  • manager usually cannot buy new assets, proceeds will be used to pay down the CLO’s liabilities
  • some deals allow the manager to make new purchases in case of credit impaired sales or credit improved sales
  • manager and equity investor prefer longer reinvestment activity for higher return, note investors prefer certainty of investment
• legal maturity date: official end date
  • before legal maturity, equity investors has the right to redeem the CLO
  • non-call period: the window from closing date during which the CLO cannot be called
    • usually 2 years
  • NAV (net asset value): the ratio between market value of the portfolio and the repayment amount of the CLO notes
    • a.k.a. market value OC
  • when called, manager sell off the assets through bid list to repay the notes and make final distribution to equity investors
  • when CLO unwind, it may hold a small number of illiquid assets, and manager will continue to oversee the fund
  • if CLO not called, manager may auction assets 2 years before, 1 year before, or on maturity as soon as the proceeds are sufficient to repay the notes
  • if proceeds are not enough to repay all the debt at legal maturity, the CLO will enter an event of default

events of default

• when serious failure of performance tests or on legal maturity but unable to pay its debt
• senior tranche owner becomes the controlling class, take control of the CLO
  • may decide to liquidate the CLO immediately or anytime
• liquidation: pay down notes in order of seniority

Supplemental indentures = changing rules

• to clarify some ambiguity in original indenture
• to accommodate some change in rating agency methodologies
• significant changes need to be approved by a majority of each class of investors
• some minor change to correct an error can be made without an investor vote
• other minor change only need rating agency confirmation that change does not affect ratings of the CLO notes

Changing players:

• for cause removal of manager: e.g. key personnel clause
• without cause removal: if sufficient investors vote for the change

Participants of CLO

SPV: Created for bankruptcy remoteness

• for CLO investors are not regarded as creditors of the originator bank
• otherwise most senior tranche of CLO cannot have rating higher than the originator bank
• criteria of bankruptcy remoteness:
  • legal separateness of SPV
  • true sale of assets from originator to SPV
  • absence of dependence of SPV on the originator for operational functions
  • absence of control of the originator over the activities of the SPV

Arranger, a.k.a. underwriter of a CLO

• an investment bank whose role is to structure the deal and sell the notes
• receives a one-off fee, typically 80–120 basis points (0.8–1.2%) of total deal size
• provide warehouse funding when it is in the ramp-up stage
• as initial purchaser on closing date (legal formality only, most of the notes are sold within the same day to investors)
• arranger may retain some notes to make a secondary market
  • arranger has best knowledge of who the original investors were, thus able to find securities for secondary buyers
• top arrangers: Citi, Morgan Stanley, BAML, Credit Suisse, Barclays, JP Morgan, Goldman Sachs, Deutsche Bank

Trustees and portfolio administrators

• indenture: contract between the issuer and trustee (usually a large commercial bank)
• trustee: represent the noteholders
  • in case of manager wants to change the terms of a CLO and requires a noteholder vote, trustee is responsible for contacting investors and arranging the vote
  • in case of disagreement between parties, trustee needs to decide which course of action is consistent with the indenture
  • will request a legal opinion from independent law firm to give it direction on a specific question
• portfolio administrator: runs practical and accounting functions of the CLO
  • books and settles trades following the manager’s instructions
  • calculates tests each month
  • makes payments and issues reports to investors
  • portfolio administrator takes direction from controlling class of investor in case of default
• fee for trustee and portfolio administrator is around 1 b.p. (0.01%) of CLO’s total size a year
• top trustees: US Bank, BNY Mellon, Deutsche Bank, Citibank, StateStreet

Law firms

• Arranger, manager, trustee will each employ a separate firm to negotiate and create documents
• documents of CLO:
  • indenture: contract between the issuer and the trustee
  • collateral management agreement: contract between manager and the issuer
  • offering memorandum/prospectus: terms of the notes for prospective buyers
  • interest rate hedge agreement: interest rate swap between issuer and swap counterparty
• top CLO arranger counsels: Ashurst, Cadwalader, Allen & Overy, White & Case, Milbank
• advisor to the arranger can expect as much as ＄400k in a deal
• advisor to manager might get 1/3 of that amount
• advisor to trustee or individual investor might get ＄40k to ＄50k
• advisor to issuer (for setting up the SPV in Cayman Is) would typically get ＄50k

Rating agencies

• all tranches except equity are rated
• investors such as insurance companies and banks require the bonds they buy to be rated
• rating agencies monitor the deals’ performance through its life and upgrading/downgrading the various notes
• arrangers usually discuss a planned CLO with officials from agencies to ensure that it will gain their desired ratings
• after crisis: rated by 1 or 2 agencies instead of 3 because more CLOs are sold to investors who do not require multiple ratings
• fee for agency:
  • initial: 3 to 10 b.p. (0.03% to 0.1%) of the amount of notes to rated
  • on-going surveillance fee: 0.5 to 1 b.p. a year

Investors

• most senior CLO tranches (AAA): banks, insurance companies, pension funds
• equity tranche: most post-crisis CLOs have single investor that owns a majority or all equity
• BBB/BB tranches: insurance companies and mutual funds
• most tranches below single A (mezzanine notes) are bought by specialist funds such as hedge funds

Manager of CLO

Manager: standalone firms, insurance companies, loan managers, or hedge fund managers

• a core team of portfolio managers (2-3 people)
• supported by a handful of research analysts, compliance specialists, marketing staff
• roles:
  • choosing and buying the initial assets
  • deciding when to sell assets due to price appreciation or likelihood of default
  • monitoring the credit quality and market value of the loans
  • finding new assets to buy with the proceeds of a sale or prepayment
• in early 2015, CLO manager had an average of 7 deals under management
• biggest managers: GSO, Carlyle, Credit Suisse Asset Management, Apollo, Ares, CIFC, Alcentra
• manager may co-invest in a CLO, usually only the equity tranches
  • manager co-investment can help CLO to be compliant with risk retention rules

Ramping the deal

• putting in place the best initial portfolio for the CLO
• ramp-up: stage of CLO’s life between warehousing phase or closing date and effective date
• once the deal has closed, the CLO starts to accrue interest on all its notes
  • negative carry: if interest coming into the deal < interest paid out
  • manager has an incentive to build the portfolio as quickly as possible

Styles of management

• style:
  • some make frequent purchases and sales
  • some specialise in finding obscure loans
  • some stick to widely held and relatively liquid loans
  • some buy loans exclusively in the primary market
• large manager will need to buy more assets across its various funds and CLOs: greater buying power
• sourcing: ability to get hold of the assets it wants to buy
• execution: ability to buy and sell at attractive prices

Key personnel provision

• give investors the right to sack the manager if key individuals quit the firm

Fee for managing a CLO:

• senior fee/base fee: manager will receive regardless the performance
  • paid out ahead of most other payment
  • around 20 b.p. (0.2%) a year of total assets
  • to ensure manager receive enough money to be able to carry out its duties
• junior fee/subordinated fee
  • paid only if there is enough money for the CLO to pay its coupon on all the CLO notes
  • usually bigger than the senior fee: 30 b.p. a year
  • ensures a healthy stream of income for the manager that is performing at least well enough to meet all its commitment
• performance fee
  • linked directly to the returns received by equity investors
  • after CLO reaches a certain hurdle rate of return for its equity
  • equity distribution are split with the manager: manager keeping 20% while equity investor receive 80%
  • the largest part of a manager’s income from a CLO

Sub-advisor: when original manager sold its right to manage a CLO

• cannot get investor approval to transfer its management contract
• the acquiring manager taking on the sub-advisory role and receives the greater part of the management fees

Manager removal:

• managers are free to resign
• right to choose a successor may be held by equity investors or require all classes of investors to approve
• deemed consent: investors who do not exercise their right to vote are deemed to have approved the proposal
• for cause removal: the controlling class of investor can vote to remove the manager for cause
  • happen only in narrowly defined circumstances, e.g.,
    • bankruptcy of the manager
    • breach of management agreement
    • manager commits fraud
• removal without cause: requires a high proportion of each class of note holder to vote

Pricing and secondary market

Pricing and call

Pricing factors

• cashflow discount rate
• likelihood of default and its recovery rate for loans
• CLO note’s coupon
• CLO note’s size of final principal payment
• weighted average life of a CLO note
  • WAL = average amount of time until the principal is repaid
  • CLO winding down because it has reached the end of reinvestment period, failing coverage tests, or called
• when the CLO equity investors choose to exercise their call option

Cashflow projection

• looks at the rules, e.g. the waterfalls and trigger levels of OC and IC tests
• early days: using spreadsheets
• now: software tools, e.g. Codean, Intex, Moody’s Analytics, SCDM
• CLO modelling is path dependent
  • a default, a test failure, or a test coming back into compliance all has knock-on effects

Defaults

• concern about: number and severity of defaults
• flat assumption of default: Same level of default every year
  • traditional modelling: flat 2%

Prepayments

• loans do not continue until their maturity
  • borrowers pay back early with little or no penalty
  • refinance
  • avoid forced to borrow at punitive rate at maturity date
• revolver loans (A loans): receive some principal back well ahead of maturity
  • a.k.a. pro-rata tranches
• CLOs: B and C loans
  • longer maturity profile but same seniority as pro-rata tranches
  • do not amortise until close to legal maturity
• forecast prepayment level: projecting today’s rate of repayments forward or look at average historical rates
  • model use flat rate for the life of the deal
• reinvestment: common assumption is that manager will be able to reinvest all prepayment proceeds while reinvestment period and 50% of them after reinvestment end date

LIBOR floor

• feature of many loans in US since 2008
• LIBOR fell to below 1% in early 2009
• States that LIBOR part of calculation = max(LIBOR floor, real LIBOR rate)

Modelling variations

• default projection: remain low for long periods of time and then jump higher during recessions
  • low flat curve with spikes
• prepayment rates and prevailing loan spread will fall and rise with the economic cycle
• post-reinvestment trading
  • need to read the indenture
  • guess how aggressively the CLO manager will choose to interpret the rules of the deal
  • make a big different to the WAL of a CLO tranche

Timing the call

• in reality equity investor will choose to call the deal before the most junior notes start to amortise
• significantly affects the CLO note’s WAL
• rational: equity investor will call at the point that they could raise a new CLO with cheaper funding
  • need to model the performance of current CLO and spread of future CLO
• not rational: when equity is held by a large number of different investors
  • difficult to trigger a call
• notes in primary market may price at a discount to reduce the investor’s risk of CLO being called early

Equity valuation

• find expected internal rate of return (IRR) of investment
• the total market value of the CLO’s asset minus the total market value of debts
  • Net Asset Value, NAV
  • market value overcollateralisation
  • problems: market price of CLO debt unknown, what manager will buy in the future is also unknown

Secondary market

Financial crisis of 2007 and 2008

• original buyers of CLOs decided to sell, created secondary market around 2008 and 2009
  • fear of performance
  • required to sell because of downgrade
• buyers: hedge funds
  • trade instead of one-off investment
  • keen to sell to lock in a gain
  • fuelled further secondary market

Secondary market: >＄20bn turnover a quarter since 2008

CLO trade: over the counter market

• no exchange which CLO trading takes place
• between dealer and investor or as part of a bid-wanted-in-competition (bid list or bwic)
  • dealer: institution that buys assets and then sells them at a later date to make a profit
  • broker: does not own the bonds at any point but simply takes a fee from seller for finding buyer
• investor with a chunk of CLO debt or equity to sell might call a handful of dealer to see which will give it the best price
• dealer with inventories of CLO debt or equity regularly send list of the CLOs they hold with an indication of the price they prepared to sell
• bwics: holder circulates to dealers and brokers a list of CLO pieces it wants to sell, and sets a time and date for the end of auction
  • the list usually start to circulate 3-4 days before deadline
  • at deadline, investor chooses the highest bid for each asset
  • or no trade will take place if bids fall short of the expectation
  • after deadline, by convention, seller circulates “colour” on trading to all bidders
    • each asset traded or not, and a price level (cover bid, the second highest bid)

Varieties of CLOs

1.0 vs 2.0:

Mid-market CLO: backed by loans to smaller companies

• majority CLO is to buy large cap loans
• mid-market loans: companies with earning below ＄50M
• bigger loans: broadly syndicated loan
• loans originated:
  • larger company: arranged (syndicated) by investment bank, markets the debt to a large number of investor
  • mid market: small club of lenders join forces to make the loan
• mid-market loans are less frequently traded than broadly syndicated loans
  • not publicly rated, usually carry shadow rating
• mid-market CLOs tend to have more static portfolios
• around 20 mid-market CLOs were issued in 2014, compared to 200 broadly syndicated US CLOs

Balance sheet CLO

• a bank securitises an existing portfolio of corporate loans
  • bank retains the equity tranche
  • act as deal’s manager in limited fashion
• Europe: balance sheet CLO from bank vs arbitrage CLO put together by asset manager
• manager retaining the equity tranche can also considered balance sheet CLOs
  • to be more common after risk retention rules in effect

Currencies

• CLO divided in to deals backed by US assets and European loans conventionally
  • distinction on currency
• Europe: shortage of loan borrowers
  • some prefer to issue in GBP, CHF, or Scandinavian currencies
  • CLO to buy multiple currencies
• max currency CLO: liabilities in more than one currency
  • currency loss incurred when an asset is sold are offset by the liabilities side
  • handful of multi-currency CLOs issued in 2007-2008

Regulations

Basel Accord: banks are required to have a basic capital ratio >8%

• Basel II: revision in 2004
• Basel III: revision in 2010
• capital ratio is sum of risk-weighted exposure amounts
  • AAA credit: 7% weight (IRB, internal ratings based approach) or 20% (standardised approach)
  • BBB– credit: 100% weight
  • Below BB– credit: 1250% weight
• Volker rule (US, mid 2016): what a bank cannot hold (covered funds)
  • CLOs are not covered fund only if it satisfies any of these: (1) 100% loans, (2) no right to remove manager, (3) 3a7-compliant structure in EUR deals
  • update: repealed for CLO in 2018

US SFA: Supervisory formula approach

• for all securitisation positions
• find risk weight to securitisation
• if cannot find, 1250% risk weight must apply

Risk retention:

• EU rule (effect 2014): manager retain 5%, vertical or horizontal
• US rule (effect 2016): Dodd-Frank act, affects deals closed on or after 1 Jan 2017
  • possibly, manager holds equity tranche

Misc

Formula

Mortgage terms

underwater: home value less than amount owed on mortgage and other liens

notice of default (NOD): sent out to homeowner after 90 days of no payments

• regulators required institution to estimate potential loss on all properties after 90 days of no payments

Dutch auction

US Treasury sell securities by Dutch auction. Auction price: The highest price that can have all shares sold. Winners pay the lowest price. If the total amount of securities bidded at the auction price is greater than the amount of securities available, the fraction is the % allocated, and applied to all bidders.

Example: 100 units put up for sale. Bids are as follows:

• ＄1.3 for 20 units
• ＄1.2 for 30 units
• ＄1.1 for 40 units
• ＄1.0 for 60 units

So the price is set at ＄1.0 (highest price \(x\) such that bids \(\ge x\) meet or exceed 100 units); and total bids are 150 units thus each bidder allocates 2/3 of the bid.