Each class of CLO debt has a different priority on cash flow distributions and a different loss exposure
By Sunil K Parameswaran
Collateralized Loan Obligations (CLOs) are securities backed by a diversified portfolio of senior secured loans. The portfolio consists primarily of first lien senior secured loans. CLOs are financed by seniority debt and variable equity. Principal and interest are distributed according to a cascade of cash flows.
Debt securities have varying seniority in the cascade. Residual cash flows go to CLO equity. For equity holders to earn a return, the interest income from the loan portfolio must exceed the interest expense from the CLO’s debt securities.
Senior secured loans are also called leveraged loans. These are loans made to companies that are rated below investment grade. They usually have a first lien and have priority over unsecured debt. These are high-risk loans, granted to borrowers who have a lot of debt and/or poor credit. Interest rates are high due to a greater risk of default.
Proceeds from the issuance of CLO debt and equity securities are used to purchase the collateral. Each class of CLO debt has a different priority on cash flow distributions and different loss exposure. Cash flow distributions start with the highest class and work their way down to stocks.
Senior debt represents the least risky debt securities. They carry the lowest coupon. They are usually rated AAA or AA. They are generally non-deferrable, i.e. missing an interest payment will amount to default. Mezzanine debt is less risky than senior debt, and therefore carries higher coupons. Equity represents a claim on all excess cash flows after the obligations for each tranche of debt have been satisfied. This is the first loss position.
Portfolio cash flows are used to make payments to different classes of debt and equity. Cash flow rights are top-down, while collateral losses are bottom-up. A tranche of debt with a given level of seniority plus will receive full interest and principal due, before any payment is made to the next level. On payment dates, the structure must carry out performance-based tests. To pass it, the principal value of the underlying collateral must exceed the principal value of the tranche, by a predetermined minimum ratio. A failure would imply a redirection of the flow of funds to reach this level, which would prevent payments to the lower rated tranches.
All tranches are based on the same collateral pool. But junior tranches absorb losses before senior tranches. The face value of a CLO’s assets is greater than the face value of its debt securities. The additional guarantee is financed by equity.
The difference between the portfolio income and the interest due on the debt tranches is called excess interest. To ensure that sufficient funds are generated to make the interest payment in a timely manner, there will be an interest coverage ratio (I/C). That is, the income from the underlying investments must exceed the interest due on the outstanding debt.
Tests are used to regularly detect warning signs of deterioration in the value of collateral. If collateral performance deteriorates, cash flows are redirected from junior tranches to purchase additional collateral and repay the highest tranche.
The author is CEO, Tarheel Consultancy Services
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