Chapter IV

Evaluating CLO Debt

Most CLO debt pays investors a coupon based on a floating market index, such as SOFR or LIBOR, and a margin. The index captures the changing cost of money over time. And the margin compensates investors for taking the risks embedded in the CLO. If the fair value of risk never changed, the CLO debt coupon would rise and fall with rates and the debt would always price at par. But the market view of risk changes constantly and, with it, the fair price of debt. Evaluating CLO debt consequently is all about evaluating the fair value of embedded risks.

The basics of evaluating CLO debt

CLO investors, like investors in almost all other assets, often rely on a checklist of items to screen securities:

• The manager. Investors will review managers’ institutional strengths and weaknesses, alignment of interests with debtholders, the liquidity of their debt and their past performance to gauge the ability of the investment team. Many investors will narrow the field to an approved list and invest only within those bounds.
• Credit enhancement. Par subordination, MVOC, original and current class ratings and overcollateralization test cushions will tell the investor something about the risk of principal loss or diversion of cash flow.
• Portfolio quality. The weighted average spread, the weighted average rating factor, the weighted average price and portfolio diversity score tell the investor something about portfolio quality and portfolio ability to take market stress. Investors will often also look at the share of loans with low ratings, such as ‘B3/B-‘ or ‘CCC’ or the share of loans trading at especially low prices to gauge the risk of breaching an overcollateralization test and diverting cash. And investors with specific concern about an industry or company may dig into loan details to weigh exposure.
• Price. The importance of security price goes beyond figuring out whether something is selling above or below fair value. It also says something about the risk of seeing debt refinanced, with securities trading above par at clear risk of refinancing and securities trading at deep discounts much less exposed. CLOs priced at deep discounts have much more potential to appreciate significantly, while CLOs priced at premiums have limited price upside.
• Tenor. Investors will also take a look at the time left before the non-call period ends and before reinvestment winds up. Longer tenors usually trade at wider spreads.

Beyond weighing these broad attributes, investors will also typically run specific return scenarios and stress tests:

Base returns to maturity. A typical approach calculates security discount margin assuming an annual repayment rate of 20 CPR, a default rate of 2 CDR and a recovery rate of 70%.

Base returns to call. An investor might run base return assumptions to call instead of maturity.

Stress returns to maturity. This scenario will typically assume higher defaults, slower repayment and lower recoveries on ‘CCC’ loans or loans trading at low dollar prices.

Breakeven defaults and losses. For lower rated CLO classes, this scenario will calculate the rate of default and recovery necessary for the class to take losses, again with consideration of ‘CCC’ loans and loans trading at low dollar prices.

The investor might assign probabilities to all these scenarios and calculate a probability-weighted discount return on each investment candidate.

Pulling together a uniform checklist across potential investments and running a probability-weighted scenario analysis should take a CLO debt investor a long way toward separating good relative value from bad. But any checklist or scenario analysis is only as good as its ability to put into clear relief the risks embedded in the CLO.

The options embedded in a CLO

CLOs embed the risk that leveraged loan borrowers or CLO managers take actions that affect the value of debt, equity or both. CLO structure can either magnify or minimize the impact of those actions. But investors can view these risks broadly as two types of options:

• Collateral options, where the behavior of the leveraged loans affects cash flow, and
• Structural options, where features of the CLO itself magnify the impact of collateral options or where the manager’s actions affect cash flow

Collateral options include loan default and repayment (Exhibit 4.1). CLO debtholders effectively sell the default and repayment options to the corporate borrowers that take out the leveraged loans. The borrowers, under different conditions, have the option to default or repay. The premium for the default and repayment options gets paid to investors through the debt margin. The more valuable the options, the higher the margin. And the less valuable the options, the lower the margin.

Structural options include a call option on CLO debt. The call option is sold by debtholders to CLO equity, and equity pays the premium through the debt margin. Structural options also include a series of tests used to protect senior CLO classes—the overcollateralization test, interest coverage test and interest diversion test. Junior classes in the CLO sell the test options and collect premium and senior classes buy the test options and pay premium.

As the value of collateral and structural options change, so does the value of CLO debt.

If a CLO investor needs to simplify the debt analysis by focusing only on the most important embedded options, then collateral default and debt call options top the list. But it is useful to understand the full set of options since they all affect debt value.

Exhibit 4.1: CLO value depends on both collateral and structural options

Evaluating collateral options

The default option

Issuers of leveraged loans hold an option to stop paying interest or principal and default. Loan defaults obviously affect the ability of CLO debt to receive timely interest and principal. The default option is the most important collateral option and arguably the most important of any option embedded in a CLO because it can have such significant impact on debt returns.

Default for any company works like an option where owners can turn over the company to debtholders if the value of the company sinks below the balance of the debt at maturity. For example, if a company and its assets have a fair value of $100 and issue $90 in debt, the company has incentive to default if fair value drops below $90 at debt maturity. Robert C. Merton at the Massachusetts Institute of Technology first described this approach to analyzing default in 1974, and both theorists and practitioners have widely applied it since.

This approach to thinking about default applies directly to CLOs. A CLO may start with a loan portfolio worth $100 and issue $90 in total debt. The most junior class, often the ‘BB’ protected by $10 of equity, might start taking principal losses if the value of the portfolio at debt maturity is less than $90. The next most junior class, often the ‘BBB’ protected by $10 of equity and $5 of subordinated debt, for instance, might take losses if the ultimate value of the portfolio is less than $85. This logic applies to every class of debt. The most senior class, typically the ‘AAA’ protected by $35 of equity and debt, might take losses only if the ultimate value of the portfolio is less than $65.

Investors can think of the attachment point of each class of debt as the strike price on a put written against the value of the CLO loan portfolio. For a loan portfolio starting out at $100, the ‘BB’ class has written a put option with a strike price of $90, the ‘BBB’ has written a put with a strike price of $85 and so on. Because the portfolio price is more likely to drop to $90 than to $85, a put written with a strike price of $90 is more valuable than one with a strike of $85. For that reason, the spread on ‘BB’ debt should be greater than the spread on ‘BBB’. And both puts are more valuable than a put with a strike price of $65. The spread on ‘AAA’ debt should be the least of all. CLO debt with less subordination—in other words, a higher strike price—gets a higher margin. The margin is premium for the more valuable put that the debt class has written to the equity class.

To evaluate the credit or default risk of CLO debt, an investor needs to focus on a handful of variables used to evaluate the debt default option:

• The amount of equity and debt subordinate to the invested class and the market value overcollateralization or MVOC of the class. The amount of subordination tells the investor how much the CLO loan portfolio would have to lose before the debt class took losses, and the MVOC provides the market’s view of the likelihood of that amount of loss. A ‘BB’ class might have 10 percentage points of equity subordinate to it, meaning the loan portfolio would have to lose 10% before the ‘BB’ took principal losses. The ‘BB’ might start with an MVOC of (100/90) or 111.11, meaning the loan portfolio market value would have to drop by more than 11% of the par amount of outstanding debt. If the market value of the portfolio dropped below $90, an investor might assume the market expected the ‘BB’ class to take losses. All else equal, as subordination or MVOC gets smaller, spreads should widen exponentially.
• Portfolio risk or beta. The riskier the loan portfolio relative to other CLOs, the greater the chance the portfolio either realizes losses through default or loses market value. Beta measures portfolio risk relative to the broad leveraged loan market. The higher the beta, the greater the relative risk. Imagine two CLO ‘BB’ classes with an MVOC of 111.11, for example, where one CLO loan portfolio has a beta of 1.0 and the second has a beta of 2.0. For a 5% drop in overall loan market value, the first CLO MVOC would drop to (95/90) or 105.5 while the second would drop to (90/90) or 100. All else equal, as beta gets larger, spreads should widen.
• Expected volatility of loan portfolio value. As the expected volatility of loan portfolio value rises, the greater the chance MVOC drops toward or below 100. This volatility might be captured by options on leveraged loan ETFs or by options on broad equity indices, such as the S&P 500. All else equal, the higher the expected volatility, the wider the spread. Volatility also multiplies the potential impact of beta.
• Time to the end of CLO reinvestment. The more time before debt gets repaid, the greater the chance that credit could either significantly strengthen or weaken, or that portfolio value could significantly rise or fall. In other words, the future distribution of credit or price widens over time, raising the possibility of actual or market value loss. All else equal, the longer the time to repayment, the wider the spread.

The repayment option

The repayment option has a relatively small influence on new CLO debt spreads because it starts to matter only after the reinvestment period. Repayment can have a big impact on CLOs leaving the reinvestment period. Leveraged loans usually come with limited prepayment penalties, making it easy for issuers to refinance if prevailing loan spreads drop or if the issuer’s credit improves. Issuers can also repay the loan in full for any other reason. Repayments affect the pace of CLO loan portfolio reinvestment and, after reinvestment ends, the return of debt principal and the weighted average life of debt. Investors commonly assume loans will repay at a 20 CPR annual rate, but actual repayments can vary widely.

Investors can gauge repayment risk from a few variables:

• Loan refinancing incentive. A drop in loan spreads should raise repayments, a rise in spreads should lower repayments. Some sources provide regular estimates of rates available for borrowers at different rating levels, but the easiest way to gauge risk is from the share of loans in a CLO portfolio trading above par.
• Expected volatility of loan value. Higher volatility implies a wider range of loan spreads over time, raising the possibility of spreads that would encourage refinancing. Options on leverage loan ETFs or broad equity indices could proxy for expected volatility.
• Loan maturity. The longer the loan, the greater the chance spreads might drop enough to encourage refinancing.

Evaluating structural options

The call option

The option to refinance CLO debt is probably the second most important option after default in assessing fair value. After a deal’s non-call period, the manager can refinance the debt if spreads have tightened sufficiently. The investor then can exchange debt with a wide margin for debt with a tighter margin. This lowers the deal’s cost of funds, but it also lowers the debtholders interest income. This makes CLO debt negatively convex when it comes to spreads—when spreads widen and the margin on existing debt drops below fair value, the debt remains outstanding longer. And when spreads tighten and the margin rises in value, the debt gets called. For this reason, CLO debt outside the non-call period can trade at a deep discount but rarely trades much above par. This pattern of pricing is the definition of negative convexity.

Investors can gauge the value of the CLO debt call from a few measures:

• Debt refinancing incentive. The clearest sign that debt is either callable or noncallable is whether it is trading above or below par. Lower spreads and higher prices for debt with a given rating and a given weighted average life raises the likelihood of a debt call and makes the call more valuable. Market spreads can drop because of strong demand for debt or low supply. Or debt can refinance at a lower spread over time as its weighted average life shortens. Wider spreads and lower prices work in the opposite direction.
• Expected volatility of debt spreads. Higher volatility implies a wider range of debt spreads over time, raising the possibility of spreads that would encourage refinancing and raising the value of the call. Options on leverage loan ETFs or equity indices again could proxy for expected volatility.
• Time to end of non-call. A shorter non-call period makes an option more valuable because the CLO can refinance debt sooner if opportunity arises. A longer non-call period makes the option less valuable
• Time to end of reinvestment. A shorter remaining reinvestment period makes the call less valuable because the option effectively expires sooner, and a longer remaining period makes the call more valuable.

The overcollateralization, interest coverage and interest diversion test options

If portfolio performance deteriorates enough and a deal fails a par overcollateralization test, then cash flow gets diverted from equity and from the failing debt classes to pay down the more senior classes. The OC test acts as an option, but a complex one that depends on the concentration of ‘CCC’ loans, defaulted loans and discount loans. At the outset of every deal, each debt class except the ‘AAA’ and ‘AA’ has a current par OC value and a designated lower value that triggers diversion of cash flow. The equity classes and junior classes effectively sell the diversion option to senior classes. The equity and junior classes get higher spreads in return, and the senior classes give spread. At the start of a deal, the circumstances likely to trigger OC diversion are highly unlikely, so the amount of spread involved is small.

The interest coverage option triggers if a deal comes up short on the amount of interest needed to pay a class of debt after paying all classes senior to it. This might happen if portfolio credit deteriorates and loans default. If interest comes up short, the deal diverts cash flow from junior classes to pay down senior classes. The equity and junior classes again effectively sell this option to senior classes. The equity and junior classes again get higher spreads, the senior classes give spread.

The interest diversion test option also relies on portfolio par balance adjusted for ‘CCC’, defaulted and discount loans. It is typically set at the same level as the must junior OC test but with a higher trigger. The interest diversion test consequently trips before the most junior OC test. Unlike the OC test, which diverts cash flow to pay down senior classes, the interest diversion test diverts cash flow to buy more loans—adding protection by adding assets rather than paying down debt. The interest diversion option is effectively sold by the equity class and bought by all debt classes. Since this test is highly unlikely to trigger at the start of a deal, the spread involved is small.

The value of the OC, interest coverage and interest diversion options depends on a few things:

• The OC, interest coverage or interest diversion test cushion. The bigger the difference between current par OC value and the trigger, the further out-of-the-money and the less valuable the option is. As the OC test cushion falls, spreads should widen. Similarly, the greater the interest coverage and the bigger the interest diversion test cushion, the less valuable the option.
• Portfolio risk or beta. The riskier the loan portfolio relative to other CLOs, the greater the chance the portfolio deteriorates and triggers diversion. Beta measures portfolio risk relative to the broad leveraged loan market. The higher the beta, the greater the relative risk. All else equal, as beta gets larger, spreads should widen.
• Expected volatility of loan portfolio value. As the expected volatility of loan portfolio value rises, the greater the chance of deterioration and diversion. This volatility might be captured by options on leveraged loan ETFs or by options on broad equity indices, such as the VIX. All else equal, the higher the expected volatility, the wider the spread.
• Time to the end of CLO reinvestment. The more time before debt gets repaid, the greater the chance that credit could either significantly improve or deteriorate and trigger diversion. In other words, the distribution of credit outcomes widens over time. All else equal, the longer the time to repayment, the wider the spread.

The things that count the most

The value of many of the options embedded in a CLO ultimately depend on a few factors:

An investor can line up alternative CLO debt investments by these variables and begin to compare fair value.

Adding or subtracting a little something for liquidity

Finally, investors have to consider liquidity both up and down the rating scale and across managers. The audience of ‘AAA’ debt is much broader than the audience for ‘BB’, for instance. Some CLO shelves have developed a broad base of investors familiar with manager infrastructure, incentives, risk profile and deal performance. New shelves or shelves that issue infrequently may have a much smaller base. After gauging the fair value of options embedded in CLO debt, investors have to gauge current and potential liquidity and adjust fair spreads accordingly.

Implications for comparing CLOs to other debt

CLOs commonly get compared to corporate debt with the same or similar rating, but it quickly becomes apparent that CLOs embed more options than corporate debt. Corporate debt definitely includes a default option that the investor sells to the issuer in return for a spread over the riskless rate. And corporate debt also has to compensate for lower liquidity than, say, Treasury debt. Investment grade corporate debt includes few if any significant call options. CLOs, by comparison, embed a loan default option, a repayment option, a debt call option as well as options based on structural tests. And CLOs have to compensate for liquidity, too. The embedded options sold by CLO debtholders create option premium or debt spread, and the more options, the more spread. As the value of CLO options change, the spread to corporate debt should change. But investors should not be surprised to find CLO spreads wide of corporate debt largely due to the greater range of options sold by the debtholder.

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