By the Numbers

A year that has put CLO managers to the (junior OC) test

Steven Abrahams and Caroline Chen | September 15, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Rising exposure to defaulted and ‘CCC’ loans this year has tested CLO managers’ ability to keep loan portfolio quality in line with benchmarks laid out at the launch of a deal. Most active CLOs have seen a drop in their junior overcollateralization test cushion, a measure of their ability to continue absorbing weak loans. Some managers have seen that cushion erode dramatically, and some barely at all. Managing to that test promises to have a significant impact on CLO debt and equity performance.

Job description: managing to the test

One of the most important jobs of a CLO manager is to keep loan portfolio quality in line with the standards set at the beginning of a deal. If quality drops too much, the deal can fail certain tests designed to stop a portfolio from drifting outside of guidelines. One of the most important is the par overcollateralization test.

A failed par overcollateralization tests diverts principal and interest from CLO equity and junior classes to classes senior to the failed test. If a ‘BB’ overcollateralization test fails, for instance, principal and interest get diverted from the ‘B’ class—if there is one—and equity to pay down principal on the ‘AAA’ class and, if there is enough diverted cash, to the ‘AA’ class and below. The test cures by paying down senior classes until there is enough collateral to repay all outstanding debt.

Failed overcollateralization tests consequently have a big impact on CLO investment performance. Principal and interest payments get suspended for equity and junior classes while principal gets accelerated for senior classes. This obviously changes the cash flow and the weighted average life of the affected classes. It is generally bad for junior debt and equity, good for senior debt. The classes with suspended cash flows can get downgraded while those with accelerated cash flows can get upgraded. CLO managers have clear incentives to avoid failing overcollateralization tests and to quickly cure any tests that fail.

A year that has put CLO managers to the test

This year has literally put CLO managers to the test, requiring most to guide loan portfolios through a rising incidence of ‘CCC’ and defaulted loans while getting the offsetting benefit of rising loan prices–all factors that affect the overcollateralization test. A rising share of ‘CCC’ and defaulted loans raises the odds of failing an overcollateralization test while rising prices lower the odds. The share of ‘CCC’ loans in the Morningstar/LSTA Leveraged Loan index from the start of this year to the end of August has gone from 6.85% to 8.23%. The share of defaulted loans has gone from 0.72% to 1.55%. But the average price of a loan has run from $92.44 to $95.36.

One way to look at a manager’s performance is through a deal’s junior overcollateralization cushion—the amount of ‘CCC’, defaulted and other types of loans that a deal could continue to absorb before failing its first overcollateralization test. If that cushion is getting thinner, the manager is running a higher risk of diverted cash flow.

Taking a snapshot of managers’ performance on junior overcollateralization tests on active deals this year involves a few steps:

Calculate the change in junior overcollateralization test from 12/31/22 to 8/30/23
Calculate the change in ‘CCC’ concentration and defaulted loan exposure
Weight each manager’s deals together by loan par balance to get summary numbers

The snapshot shows significant differences across managers and differences in the influence of ‘CCC’ and defaulted loans, both loan types significant influences on the ability of a deal to stay on course.

Sizable changes across managers in junior OC test cushion

Across managers, only 11 out of 123 increased their weighted average junior overcollateralization test cushion from the start of the year through August. The change in managers’ junior overcollateralization test cushion, weighted by their CLOs’ collateral par balance at the end of August, ranged from a gain of 6.8 percentage points to a decline of 31.9 percentage points, with a median change of -0.73 percentage points (Exhibit 1). It is worth mentioning that a few managers showed a large change in test cushion merely because most of the CLOs they manage are amortizing in the post-reinvestment period or because managers only have one or two deals outstanding.

Exhibit 1. A wide range of change across CLO managers in junior OC test cushion

Notes:
1) w.a.dOC = managers’ CLOs junior OC test cushion change from 12/31/22 to 8/30/23, weighted by CLO collateral par balance as of 8.30.23. pp = percentage points. The table includes 123 managers. 2) The table includes 1,631 outstanding BSL CLOs issued from 2011 to 2022. High-flex CLOs and static CLOs are NOT included.
Source: INTEX, Santander US Capital Markets

Across the major influences on the junior overcollateralization cushion, the rise in defaulted loans plays a clear role and the rise in ‘CCC’ a slightly lesser role.

As exposure to defaulted loans rises, junior OC test cushion falls

Corresponding to the rising default rates in the leveraged loan index, the share of defaulted loans in BSL CLOs rose from a median 0.19% at the end of 2022 to 0.57% in August, a rise of 0.38 percentage points. Across the 123 active managers analyzed here, the share of loan principal in defaulted loans showed a wide range of change. At the high end, one manager saw the defaulted loan share rise by 2.48 percentage points and, at the low end, one manager saw the defaulted share drop by -0.34 percentage points. A positive change in defaulted loan exposure should reduce the junior overcollateralization test cushion, and, in fact, managers this year that saw a rise in defaulted loans also tended to see a drop in junior overcollateralization test cushion (Exhibit 2).

Exhibit 2. Rising defaults have contributed to declining junior OC test cushions

Notes:
1) w.a. dOC = managers’ junior OC test cushion change from 12/31/22 to 8/30/23, weighted by CLOs collateral par balance as of 8.30.2023. w.a.dDL = managers’ defaulted loan par balance exposure change from 12/31/22 to 8/30/23, weighted by CLOs collateral balance as of 8.30.2023. pp = percentage points. 2) the exhibits include 115 managers with their w.a.dDL between 2.5^th percentile (-0.34 pp) and 97.5^th percentile (2.48pp).
Source: INTEX, Santander US Capital Markets

As exposure to ‘CCC’ loans rose, junior OC test cushion tended to drop

Following the trend seen in the defaulted loans, ‘CCC’ loans in BSL CLOs also increased from a median 4.6% of the portfolio at the end of 2022 to 6.45% in August, an increase of 1.85 percentage points. Managers again showed wide dispersion. At the high end, one manager saw the ‘CCC’ share increase by 5.11 percentage points, and at the low end, one manager saw the ‘CCC’ share drop by 1.06 percentage points. A rising ‘CCC’ share also tended to come with a falling junior overcollateralization test cushion, although the relationship is noisy (Exhibit 3).

Exhibit 3. Rising ‘CCC’ loans have also contributed to declining junior OC test cushion

Notes:
1) w.a. dOC = managers’ junior OC test cushion change from 12/31/22 to 8/30/23, weighted by CLOs collateral par balance as of 8.30.2023. w.a.dCCC= managers’ ‘CCC+ or lower’ rated loan par balance change from 12/31/22 to 8/30/23, weighted by CLOs collateral balance as of 8.30.2023. pp = percentage points. S&P rating used. 2) the exhibits include 115 managers with their w.a.dDL between 2.5^th percentile (-1.44 pp) and 97.5^th percentile (5.13 pp).
Source: INTEX, Santander US Capital Markets

Implications for debt and equity performance

CLO debt and equity spreads should reflect a deal’s junior overcollateralization test cushion since breaching the test will change deal cash flows. A thinner cushion is a clear negative for equity and any classes subject to seeing cash flow diverted. It is probably positive in the long run for debt likely to see principal accelerated, although the declining quality of the loan portfolio could be an offsetting negative. In a market with thinning test cushions, manager has become a more important factor than usual.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

Caroline Chen
caroline.chen@santander.us
1 (646) 776-7809

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