Chapter VII

An Option-Adjusted Model of CLO Risk and Return

Most of the work involved in evaluating CLOs focuses on the options embedded in loans and structure, but an approach first described by Robert Merton and applied to corporate debt may eventually make the work much easier. An option-adjusted model of CLO value would open a new frontier in CLO investing.

An option view of CLOs

Any credit instrument, including CLO debt, runs the risk that the issuer will not repay. Merton argues the issuer will default if the market value of company assets drops below the face value of debt at maturity. The issuer effectively owns company assets and a put option on the assets struck at a price equal to the face value of outstanding debt and with expiration of the option set at maturity. Corporate debt, on the other hand, equals a long position in a riskless bond and a short position in a put option.

Merton makes the simplifying assumptions that the issuer has only a single zero-coupon bond outstanding and either repays the debt or liquidates the company. Other analysts extend Merton’s model to companies issuing debt with covenants, senior and subordinated features and coupons. Other work handles taxes and bankruptcy costs. KMV, a company providing credit analytics, has adapted Merton’s framework to other complexities of corporate balance sheets, including callable debt and debt with different maturities. Perhaps as importantly, Merton’s approach has allowed analysts to use market pricing of risk as an alternative to traditional projections of loan or bond default.

CLOs have a number of features that make application of Merton relatively direct:

• The market value of the CLO asset is transparent. The portfolios of leveraged loans that constitute CLO assets largely trade in active markets, allowing a Merton framework to use asset value directly rather than inferring it from publicly traded equity, which is common practice for corporate debt.
• The expected volatility of asset value is priced. Options on portfolios of leveraged loans also trade in active markets, offering some measure of market expectations for the volatility of portfolio price.
• CLO debt structure is relatively simple. Most CLO debt remains outstanding until it is either called or, after a reinvestment period, fully amortizes. And once all debt is repaid, the residual value of the transaction goes to equity. This parallels Merton’s assumption that the company repays all debt and liquidates residual value
• CLO debt relies exclusively on the assets for repayment. CLOs do not have recourse to bankruptcy, distressed exchanges or other means of meeting debt obligations beyond the cash flow and value of the assets themselves.

While CLO managers can refinance debt or reset transactions, the outcomes of those efforts are not relevant for evaluating originally issued debt or equity.

Applied to CLOs or any structured credit, a Merton approach has to incorporate the subordination structure of the debt. The most junior class of CLO debt absorbs losses until its principal balance drops to zero, and then the next most junior class absorbs losses. This continues until losses attach to the most senior class.

In a typical CLO, equity might take the first 10% of losses (Exhibit 7.1). A ‘BB’ class of debt might take losses from 10% to 15%, a ‘BBB’ class might take losses from 15% to 20%, a ‘A’ class might take losses from 20% to 25%, a ‘AA’ class might take losses from 25% to 35%, and a ‘AAA’ class might take losses from 35% to 100%.

Exhibit 7.1: The structure of a typical CLO

Source: Santander US Capital Markets

CLO structure also allows the issuer to call the debt. Most CLO debt is indexed to 3-month SOFR or LIBOR and pays a margin over the index. The issuer will exercise the call when the market will allow refinancing to a lower margin.

Finally, CLO structure includes protections for senior classes. Different events can trigger diversion of cash flow from equity and junior to senior classes. The equity and junior classes have sold options to the senior classes. If the concentration of ‘CCC’ loans exceeds a threshold of typically 7.5%, for example, the structure calculates whether the CLO has enough value to repay debt. If the calculations show insufficient value, the interest and all principal due to certain junior classes get diverted to senior classes until CLO value is sufficient to cover outstanding debt. CLOs include several tests of this sort. A missed interest payment or other event of default can trigger a transfer of certain control rights to the most senior class, an option sold by the equity class to the most senior class.

Applying Merton’s framework to CLOs, the CLO debt breaks down into a series of riskless notes indexed to 3-month SOFR or LIBOR each with a set of embedded options (Exhibit 7.2). The equity class owns a put on the value of the underlying leveraged loan portfolio struck at 90% of initial value and a call on all debt struck at par—or at some small premium to par to cover transaction costs. It also has sold diversion and control options. The ‘BB’ class with a principal balance equal to 5% of initial portfolio value owns a riskless note paying 3-month LIBOR, has sold a put option on portfolio value struck at 90% and bought a put struck at 85%, and has sold a diversion option. Each successive class also owns a riskless note paying 3-month LIBOR, has sold a put with a high strike and bought a put with a low strike, and holds positions in diversion or control options. The most senior class, the ‘AAA,’ also owns a riskless note paying 3-month LIBOR, has sold a put struck at 65% of initial portfolio value and holds diversion and control options.

Exhibit 7.2: An option view of a typical CLO

Source: Santander US Capital Markets

Each class has also sold a call option. For practical purposes, this is equivalent to a call on the market value of the CLO loan portfolio with a strike price equal to its initial value. When the market reprices the loan portfolio higher, existing debt should trade above par. Each class has sold a call struck at initial portfolio value on the notional par balance of the class.

Different classes have also sold or bought different options on diverting cash flows or on having control over different aspects of CLO management, such as the decision to liquidate a deal. These options have no traded market instrument to indicate value. Their value is probably best captured by any residual value left over in a CLO after accounting for all other observable market value.

A simulation approach to CLO fair value and hedging

By drawing on public markets for portfolios of leveraged loans, such as the exchange traded fund BKLN and options on BKLN, investors should be able to simulate the market-implied future distribution of CLO leveraged loan portfolio market value and apply some simple rules to infer relevant loan and CLO cash flows. Once the investor has estimated CLO cash flows, calculating an option-adjusted spread—a spread that, on average, reprices the cash flows to the current price—becomes straightforward. And by systematically varying some of the assumptions in the calculation, the investor can estimate price CLO class sensitivity to a variety of risks. The process is easily described as a series of steps.

Step 1: Generate future paths of CLO loan portfolio market value

Consider the spot price of BKLN or a similar ETF as 100% of a given CLO loan portfolio’s market value. Options on BKLN imply a period-to-period volatility in market value. The price of the loan portfolio consequently evolves according to standard option pricing assumptions adjusted for the effective upper limit on the price of a callable loan.

By sampling repeatedly from a distribution of the percentage change in portfolio value over a 1-month period, implied by a par or at-the-money option on BKLN, the analysis can simulate the market value of the portfolio over time (Exhibit 7.3). Portfolio market value along with interest received contains valuable information for estimating loan and CLO cash flows.

During a CLO’s reinvestment period, the analysis assumes any repaid loan principal gets reinvested on average at the price of the portfolio. After the reinvestment period, the analysis assumes a certain rate at which repaid principal is used to retire debt until the most junior outstanding tranche balance goes to zero. At that point, the remaining portfolio is liquidated at market value and the proceeds delivered to equity.

Exhibit 7.3: A graphic example of simulated market value for a CLO loan portfolio

Source: Santander US Capital Markets

Step 2: Track CLO portfolio behavior along each path

Each simulated path represents the value of the CLO loan portfolio over time, but the portfolio has an underlying distribution of loans. The analysis can make a fixed assumption about the distribution of loan attributes or can pull the empirical distribution from each CLO. Each portfolio should move according to the appropriate deal or manager beta to the Morningstar/LSTA Total Return Index. The key behaviors of the loans are inferred from price:

• Refinancing: as the price moves up to some threshold or the average margin moves down, loans will refinance. In a par portfolio, all margins represent the market price for the underlying risk in the loan. A par loan at SOFR + 400 bp is riskier than one at SOFR + 375 bp, which is riskier than one at SOFR + 350 bp. If the average portfolio price moves up sufficiently or the average margin moves down, it is reasonable to assume all loans will refinance into an equivalently risky par loan at a lower margin.
  If the average margin moves down by 25 bp, for example, the loans will refinance respectively into SOFR + 375 bp, SOFR + 350 bp and SOFR + 325 bp.
  This last example assumes margins at all levels of risk move by the same amount, but the analysis alternatively could assume that riskier and safer loans move at a different beta to the average. A ‘BB’ loan might move at a beta of 0.8, a ‘B’ at 1.09 and a ‘CCC’ at 1.70.
  Premium and discount loans would also have to move up in price enough or see a sufficiently lower coupon to refinance. A loan trading at $95 with an SOFR + 250 bp coupon would need to see price move up high enough or average margin move down enough to refinance into a par loan at SOFR + 225 bp. Other par loans in the portfolio might refinance several times along the way as prices rose and par margins fell.
• Maturity. The analysis can assume a constant rate of repayment due to maturity regardless of portfolio price or margin
• ‘CCC’ concentration. If loan price drops below a threshold, such as $80, the analysis can assume the loan has dropped to ‘CCC’ and should be counted against the CLO limit on ‘CCC’ holdings.
• ‘D’ concentration. If loan price drops below a second threshold, such as $40, the analysis can assume the loan has dropped to ‘D’ and should be counted against the CLO limit on defaulted holdings; the analysis could also assume the loan no longer pays interest.

Step 3: Track CLO debt and equity cash flows along each path

At each period, the analysis evaluates CLO debt and equity cash flows. This step should reflect the appropriate structure and spot MVOC of the CLO:

• Income. Since the analysis tracks the composition of the loan portfolio at each point, it can calculate available portfolio income and allocate it to taxes, fees, administrative expenses, debt in order of seniority, junior fees, incentive fees and pay the residual to equity. The analysis can assume a single forward path of index values for calculating interest income.
• OC tests. Since the analysis tracks the concentration of ‘CCC’ and ‘D’ loans and discount obligatons, it can test whether the CLO fails any OC tests and can divert income from junior to senior classes.
• Call tests. The analysis can rely on portfolio price reaching a threshold to trigger a call of all CLO debt after the non-call period ends or alternatively can try to use cash flow to equity to trigger a call of CLO debt.
• Principal. The analysis can use refinanced and maturing principal after the reinvestment period to pay down debt in order of seniority. The analysis can assume that principal matures at the average price of the portfolio, implicitly assuming losses, and pays down debt until available market value. If a portfolio constantly priced at $90 after reinvestment, a fixed amount of principal might mature each period until all matured, leaving no value left to pay equity.

Step 4: Calculate OAS for each debt class and IRR for equity

• For each class, find the spread over a single path of forward values of the CLO index that creates an average price across all simulated paths equal to the spot market price.
• For equity, calculate cash flow IRR across all simulated paths and take the arithmetic average

Step 5: Calculate risk for each debt class

• Shift the assumed starting normalized price from 100 to a higher value, such as 102.5, and a lower value, such as 97.5, and reprice each class at the initial calculated OAS. Convert the price change in the class to a duration and convexity.
• Shift the assumed starting volatility to a higher and lower value, reprice each class at the initial calculated OAS and calculate a duration of volatility.
• Shift other key parameters of the analysis to measure outcome sensitivity

The result of the simulation should be an option-adjusted spread for each class of debt, the expected IRR of equity and accompanying risk metrics that the investor could use to hedge with BKLN, options on BKLN or other market instruments used to calibrate the analysis. The OAS and risk statistics create simple measures that allow comparison of a wide range of CLOs.

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