COLLATERALIZED

LOAN OBLIGATIONS
(CLO)

4.12.2017 Dr. Janne Gustafsson

OUTLINE

1. Structured Credit

2. Collateralized Loan Obligations (CLOs)

3. Pricing of CLO tranches

2
 Structured Credit

3
WHAT IS STRUCTURED
CREDIT?
• Structured credit investments are bonds issued by a
special purpose vehicle (SPV)
– Corporation set up solely for the purposes of securitization

• Bonds are ordered in a priority of payments

– Most senior gets paid first, junior-most last

• SPV uses the money raised by selling the bonds to

purchase a portfolio of investments + pay setup fees

• SPV distributes all income (interest etc.) in the order of

priority to the bonds (unless reinvested)
4
SIMPLIFIED STRUCTURED
CREDIT INVESTMENT
Bonds
Collateral Investment portfolio: €78MM
€150 MM €75MM
AAA: L+90
Senior-most

Risk increases
Collateral 1 Investment 1
€50MM €25MM
Collateral

Colalteral
Senior mezzanine AA: L+150

Collateral 2 Investment 2 Mezzanine A: L+225

€100MM €50MM Junior mezzanine BBB: L+350

Issuer SPV Junior-most NR: Rest

5
TERMINOLOGY: TRANCHES
• Each priority class of bonds is called a tranche
– Bonds are also often referred to as ”notes”

• Most-senior tranche is often labeled A note, second-most-

senior B note, etc.

• Junior-most tranche is called a subordinated note, or

equity tranche
– Equity tranche is still a bond; the actual equity of the SPV is
normally held by a charitable trust

• Other tranches are colloquially referred to by their rating

– For example, AAA tranche = A note, AA tranche = B note, …
6
SIMPLIFIED STRUCTURED
CREDIT INVESTMENT
Bonds
Collateral Investment portfolio: €78MM
€150 MM €75MM
AAA: L+90
A Note (60%)

Risk increases
Collateral 1 Investment 1 €46,8MM
€50MM €25MM
Collateral

Colalteral
B Note (15%) AA: L+150

Collateral 2 Investment 2 C Note (10%) A: L+225

€100MM €50MM
D Note (5%) BBB: L+350

Issuer SPV Sub Note (10%) NR: Rest

7
CLASSIFICATION OF STRUCTURED
CREDIT INSTRUMENTS
• Structured credit instruments can be classified based on
what kind of investments they hold
• Leveraged loans (BB-CCC-rated corporate loans)
 CLO (Collateralized Loan Obligation)
• Residential mortgages
 RMBS (Residential Mortgage Backed Security)
• Commercial mortgages
 CMBS (Commercial Mortgage Backed Security)
• Assets  ABS (Asset Backed Security)

• Number of instruments bought by the SPV can vary widely

– CLO: 100+ loans
– CMBS: 1-5+ loans (but possibly 100+ properties as collateral)
8 – RMBS: 1000+ mortgages and properties as collateral
CLASSIFICATION OF STRUCTURED
CREDIT INSTRUMENTS (2)
• Certain types of structured credit investments are
actively managed, in particular CLOs
– CLO manager can buy and sell loans
 Portfolio changes over time
– Requires the existence of an actively traded asset market
– CLO resembles an active fund investing in leveraged loans

• CMBS, RMBS, and ABS are typically static

– Initial investment portfolio does not change
• Selected by the arranger of the investment (e.g. investment bank)

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 Collateralized Loan
Obligations

10
OVERVIEW OF COLLATERALIZED
LOAN OBLIGATIONS
• Contains typically 100-300 loans
– Typically 90%+ 1st lien, senior secured leveraged loans
– Loans are typically broadly syndicated
• Market priced, large corporations, liquid, wide range of loan investors

• Actively managed by a CLO manager

– Buys the loans from the loan market at the start

• Can reinvest during the reinvestment period, and limited

ability after the reinvestment period (normally 4 years)

• Can be called after a non-call period (normally 2 years)

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 SAMPLE CLO
Tranches:
Investment portfolio: L+161 (rated tranches only)
Companies and collateral Loans: L+380 €413MM
€800MM €400MM
AAA: L+90
A Note(60%)

Risk increases
Company 1 (BB-): Loan 1 €248MM
Collateral
Collateral €8MM €4MM

Collateral
B Note (9%) AA: L+150

Loan 2 C Note (6%) A: L+225

Company 2 (B+): €4MM D Note (5%) BBB: L+350
Collateral €8MM …
(total 100 loans) E Note (7%) BB: L+600
…
”Issuer” SPV Sub Note (13%) NR: Rest
(total 100 companies)
Buys and
Issues bonds
sells

CLO Manager
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KEY ELEMENTS IN A CLO
1. Loan portfolio
– Quality and mix of loans

2. Structural protections and features

– Triggers and trigger levels
– Reinvestment criteria such as Weighted Average Life Test

3. CLO manager quality and style

– Ability to trade, avoidance of defaults, high returns, style

4. Commercial topics
– Management fee, setup costs
– Purchase price of notes
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1. LOAN PORTFOLIO

• CLO portfolio can contain many kinds of loans and bonds

– Senior secured 1st lien loans (leveraged loans)
– 2nd lien loans
– Senior unsecured loans
– Junior unsecured (mezzanine) loans
– Senior secured floating rate notes (bonds)
– Senior unsecured floating rate notes (bonds)
– Senior secured fixed-rated bonds
– High yield bonds (subordinated unsecured bonds)

• Normally no structured credit or synthetic securities

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PORTFOLIO STATISTICS

• Ratings vary normally from CCC to BB

– Average rating is measured by Weighted Average Rating Factor
(WARF)
– Also the tail loan quality is important, not just the average

• Market value of loans is normally close to 100

– Loan price distribution is an important indicator of default risk
• E.g., share of loans priced <70, <80, <90
– Some loans are unpriced  Risk analysis more difficult, illiquid

• 1st lien loan spreads vary from L+2.75% to L+5.00%+

– More from 2nd liens and unsecured loans and bonds
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TYPICAL PORTFOLIO LIMITATIONS
1. Concentration limitations:
– At least 90% 1st lien loans
– At most 10% second lien / unsecured loans
– At most 5% fixed rate assets
– At most 7.5% CCC-rated investments
– At most 60% covenant-lite loans
– Issuer concentration at most 2%
– Industry concentration at most 10%

2. Weighted Average Life at most 8-8.5 years less the time

the CLO has been outstanding

3. Matrix limit for portfolio spread, diversity score, and

WARF
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SAMPLE LOAN PORTFOLIO

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SAMPLE PORTFOLIO STATISTICS Group: Total HARVST16, Total
Prepay Group Graph Apr 17 Feb 17 Jan 17 Dec 16 Nov 16 Oct 16 Sep 16
Characteristics High-Yield Loans
Original Balance 440 000 000 440 000 000 440 000 000 440 000 000 440 000 000 440 000 000 440 000 000 440 000 000
Current Balance 437 541 146 437 541 146 440 009 310 440 472 026 448 789 138 439 800 418 381 583 578 440 000 000
Principal Collection Account 2 507 747,41 2 507 747,41 24 898,52 159 977,76 -8 207 131,63 355 631,30 58 599 423,85 0,00
Interest Collection Account 0,00 0,00 7 807 490,34 4 865 630,07 3 682 183,60 2 506 592,43 1 367 702,07 1 100 000,00
Senior Management Fee (%) 0,15 0,15 0,15 0,15 0,15 0,15 0,15 0,15
Subordinate Management Fee (%) 0,35 0,35 0,35 0,35 0,35 0,35 0,35 0,35
Incentive Management Fee Excess (%) 20,00 20,00 20,00 20,00 20,00 20,00 20,00 20,00
Incentive Management Fee IRR Threshold (%) 12,00 12,00 12,00 12,00 12,00 12,00 12,00 12,00
Gross Coupon 4,1315 4,1315 4,2719 4,3579 4,3842 4,4700 4,5587 4,7383
WAS 3,8903 3,8903 3,9886 4,0497 4,0633 4,0969 4,2106 4,2566
WAVG Rem Term 70 70 70 70 71 71 71 70
Number of Assets 176 176 181 171 171 159 142 117
Defaulted Securities ($) 0,00 0,00 0,00 0,00 0,00 0,00 0,00 -
Last Equity Dividend Yield 11,8349 11,8349 0,0000 0,0000 0,0000 0,0000 0,0000 0,0000
Last Equity Dividend Yield (using implied bal) 16,1147 16,1147 0,0000 0,0000 0,0000 0,0000 0,0000 0,0000
NAV (assets at MV) 441 283 720 441 283 720 444 337 574 443 870 043 441 934 114 441 521 949 441 816 846 440 000 000
NAV Price Coverage % (assets at MV) 100,00 100,00 99,39 100,00 100,00 100,00 100,00 0,00
Market Price 100,2822 100,2822 100,9841 100,7351 100,3013 100,3106 100,4282 -
Principal Collection Account before Payments (€) 2 507 747,41 2 507 747,41 24 898,52 159 977,76 -8 207 131,63 355 631,30 58 599 423,85 -
Interest Collection Account before Payments (€) 9 663 380,10 9 663 380,10 7 807 490,34 4 822 716,07 4 169 740,60 2 506 592,43 1 367 702,07 -
Collateral Quality
Weighted Average Rating Factor 2 587 2 587 2 591 2 584 2 570 2 571 2 554 -
Weighted Average Rating Factor Limit 2 768 2 768 2 822 2 816 2 848 2 776 2 809 -
Moody's Diversity Score 49 49 48 46 46 44 41 -
Moody's Diversity Score Limit 40 40 40 40 36 36 36 -
Weighted Average Life 5,66 5,66 5,28 5,69 5,70 5,69 5,73 -
Weighted Average Life Limit 7,53 7,53 7,63 7,73 7,80 7,88 7,96 -
Moody's Weighted Average Recovery Rate (%) 45,80 45,80 45,80 45,70 45,60 45,40 45,90 -
Moody's Weighted Average Recovery Rate Limit (%) 43,53 43,53 43,00 42,94 43,00 43,01 42,83 -
Weighted Average Coupon (%) 4,71 4,71 4,71 4,71 4,65 4,56 4,71 -
Weighted Average Coupon Limit (%) 0,00 0,00 0,00 0,00 0,00 0,00 0,00 -
Weighted Average Spread (%) 4,05 4,05 4,20 4,33 4,33 4,39 4,52 -
Weighted Average Spread Limit (%) 3,90 3,90 4,00 4,00 4,20 4,20 4,20 -
Ratings
Caa1 or Less (%) 0,00 0,00 0,20 0,00 0,00 0,00 0,00 -
Caa1 or Less Limit (%) 7,50 7,50 7,50 7,50 7,50 7,50 7,50 -
Caa1 or Less (€) 916 666,67 916 666,67 916 666,67 0,00 0,00 0,00 0,00 -
CCC+ or Less (%) 0,00 0,00 0,00 0,00 0,00 0,00 0,00 -
CCC+ or Less Limit (%) 7,50 7,50 7,50 7,50 7,50 7,50 7,50 -
CCC+ or Less (€) 0,00 0,00 0,00 0,00 0,00 0,00 0,00 -
Concentrations
Assets that are Cov-Lite Loans (%) 4,40 4,40 3,70 5,10 3,90 5,20 4,00 -
Assets that are Cov-Lite Loans Limit (%) 30,00 30,00 30,00 30,00 30,00 30,00 30,00 -
Assets that are Senior Secured (%) 99,10 99,10 99,10 99,10 99,30 99,30 99,30 -
Assets that have Fixed Rate Coupons (%) 2,90 2,90 2,90 2,90 3,30 3,70 2,70 -
Moody's Industry
S&P Industry
Moody's Ratings
NR 28,69 28,69 28,24 28,04 27,23 26,72 29,94 18,58
B1 26,42 26,42 29,01 27,34 29,99 29,66 26,75 23,06
B2 26,27 26,27 25,35 25,59 25,73 25,83 21,71 11,61
Ba3 9,63 9,63 8,74 11,71 9,89 11,75 13,17 8,48
Ba2 4,25 4,25 4,27 2,70 2,65 2,00 2,83 2,81
18 (more) - - - - - - - -
Ba1 3,49 3,49 3,48 3,48 3,41 2,91 3,36 1,25
2. KEY STRUCTURAL FEATURES

• Priority of payments
– Interest waterfall
– Principal waterfall

• Triggers in priorities of payment waterfalls

– Overcollateralization tests
Coverage tests
– Interest coverage tests
– Reinvestment / interest diversion test

• Reinvestment criteria
– Collateral quality tests
– Weighted average life test
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PRIORITY OF PAYMENTS

(often 2% expected)

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WATERFALL TRIGGERS

Overcollateralization (OC) Test is roughly:

Loan Portfolio Principal / Sum of note principal from AAA to test rating level

Reinvestment Diversion Test is normally the same as junior-most OC Test

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REINVESTMENT TESTS
• Certain tests influence manager’s ability to reinvest
– WARF, WAS, WAC, WAL, WARR, Diversity Score

• These collateral quality tests need to be satisfied for

reinvestment to be allowed without limitations
– CCC tests normally influence OC Tests rather than reinvestment

• If a collateral quality test fails, then the effect depends on

the CLO:
– In some, reinvested loan cannot worsen the breach of the test
– In some, reinvested loan needs to bring the test to pass; if
impossible, then reinvestment cannot happen and AAAs are paid
down instead
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COLLATERAL QUALITY TESTS

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3. CLO MANAGER

• Quality of the CLO manager is important

– Better performance for equity
– More liquidity and less risk for rated notes

• Expected defaults
– Manager should not be too aggressive
– Most important for debt

• Achieved returns
– Manager should not be playing too safe
– Important mainly for equity

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CLO MANAGER (2)

• ”Skin in the game”

– Does the manager own some of their own equity?
– Or do they own a ”vertical slice”, e.g. 5% of each tranche?
• Normally required nowadays by risk retention rules
– Are equity owners aggressively pursuing high returns?
• CLO manager possibly taking undue risk

• Style
– Manages for equity or for debt, par build, low/high coupon, etc.
– Frequency of trading

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4. COMMERCIAL POINTS

• CLO manager fees, normally:

– Senior fee 15 bps
– Junior fee 35 bps
– Performance fee: 20% of equity cash flow after 15% IRR

• When buying equity in primary market:

– Setup fees
• Normally investment bank charges about 1% of the notional
• Other setup costs are about 1-2 million
– Ramp-up costs
• Interest lost between purchasing loan portfolio and CLO issuance
• Normally around 1 million

26
COMMERCIAL POINTS (2)

• Purchase price of equity

– Normally around 90-95 compared to principal of equity
– Discount is related to how much net fees the arranger gets
– Additional discounts possible if buying large part of equity

• Purchase price of a rated note vs. coupon of the note

– Rated note can achieve the same return with a high price and high
coupon or with a low price and low coupon
– Generally low price / low coupon is better for a callable floating rate
note, as long as weighted average life is calculated correctly
• Introduces WAL risk, but the value of the sold call option is less

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 Pricing of CLO notes

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KEY TOPICS

• Valuation techniques
– Monte Carlo simulation
– Expected value

• Cash flow model assumptions

– Expected default rate
– Expected recovery rate
– Expected prepayment rate
– Default correlations
– Reinvestment assumptions
– Recovery lag
– Grace period for defaults, etc.
29
VALUATION TECHNIQUES

• Monte Carlo simulation

– Run a large number (10000) simulations based on randomized
defaults in the portfolio
– Produces a distribution of possible outcomes

• Expected value approach

– Calculated expected cash flow stream based on expected default
rates and other expected statistics
– Useful for equity
• But does not tell much about breadth of possible outcomes
– Normally under expected cash flow, rated notes never suffer losses
• Monte Carlo more useful for the analysis of rated notes
• Often also breakeven default rate computed in the expected value
30
approach
VALUATION ASSUMPTIONS

• Conditional Default Rate (CDR): 2%

– WARF implies normally a CDR 3-3,5%
– Selection effect means that very few loans default in the first years

• Recovery rate for

– 1st lien loans: 65% (historical experience 60%-70%)
• Covenant light: 60%
• Senior secured bonds and floating rate notes: 55%
– 2nd lien loans: 20%
– Mezzanine: 2%

•  Expected loss rate ~0,60 - 0,80% p.a.

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VALUATION ASSUMPTIONS (2)

• Conditional Prepayment Rate (CPR): 20%

• Reinvestment into the same kind of portfolio as currently

32
PRICING OF SUBORDINATED NOTES

• Present value (PV) can be calculated for a given required

rate of return (often 8%-12%); or

• Internal rate of return (IRR) can be calculated if the

purchase price is known

• Next a few simplified calculations of subordinated note

returns
– In reality, complex Monte Carlo or expected value calculation based
on defaults, correlations, reinvestment, structural triggers, etc.
– Still, simple calculations are useful for sense checking results, since
complex calculations are often a black box

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PRICING OF SUBORDINATED NOTES
SIMPLE RETURN: UPFRONT COSTS AMORTISED
1. Simple Sub Note Return Calculation EUR MM Interest rate Cash flow (EUR)
Assets 400,00 3,80 % 15,20
Management fee 400,00 -0,50 % - 2,00
Credit losses 400,00 -0,60 % - 2,40
Amortisation of upfront costs - 1,09

Total net income 400,00 2,43 % 9,71

Liability costs - 359,31 1,61 % - 5,80

Net income for sub note 3,91

Sub note purchase price 48,32

Return per annum % 8,09 %

Total liability structure principal 413,00 (1)

Total rated debt principal 359,31 (2)
Sub note notional 53,69 =(1) - (2)
Sub note purchase price % 90 %
Sub note purchase price EUR 48,32
Sub note equity principal 40,69 =Asset principal less liability principal
Loss amortisation over 7,00 years
Total loss - 7,63 =Subnote equity principal - purchase price
Per year - 1,09

34
PRICING OF SUBORDINATED NOTES
IRR: CREDIT LOSSES DEDUCTED FROM CASH FLOW

Year BoP Principal Interest Total EUR MM Interest rate Cash flow (EUR)
0 - 48,32 - 48,32 Assets 400,00 3,80 % 15,20
Management fee 400,00 -0,50 % - 2,00
1 5,00 5,00 Credit losses 400,00 -0,60 % - 2,40
2 5,00 5,00
3 5,00 5,00 Total net income 400,00 2,70 % 10,80
4 5,00 5,00
Liability costs - 359,31 1,61 % - 5,80
5 5,00 5,00
6 5,00 5,00 Net income for sub note 5,00
7 40,69 5,00 45,69

IRR 8,60 %

Total liability structure principal 413,00 (1)

Total rated debt principal 359,31 (2)
Sub note notional 53,69 =(1) - (2)
Sub note purchase price % 90 %
Sub note purchase price EUR 48,32
Sub note equity principal 40,69 =Asset principal less liability principal

35
PRICING OF SUBORDINATED NOTES
IRR: CREDIT LOSSES DEDUCTED FROM LOAN PRINCIPAL
Cashflow
Year BoP Assets Interest Management
Liabilities
fee Liability costs
Income Principal Total
0 400,00 - 48,32 - 48,32
1 397,60 15,20 - 2,00 - 359,31 - 5,80 7,40 7,40
2 395,20 15,11 - 1,99 - 359,31 - 5,80 7,32 7,32
3 392,80 15,02 - 1,98 - 359,31 - 5,80 7,24 7,24
4 390,40 14,93 - 1,96 - 359,31 - 5,80 7,16 7,16
5 388,00 14,84 - 1,95 - 359,31 - 5,80 7,08 7,08
6 385,60 14,74 - 1,94 - 359,31 - 5,80 7,00 7,00
7 383,20 14,65 - 1,93 - 359,31 - 5,80 6,92 23,89 30,81

IRR 9,46 %

Total liability structure principal 413,00 (1)

Total rated debt principal 359,31 (2)
Sub note notional 53,69 =(1) - (2)
Sub note purchase price % 90 %
Sub note purchase price EUR 48,32
Sub note equity principal 40,69 =Asset principal less liability principal

36
PRICING OF SUBORDINATED NOTES
MORE DETAILS: RECOVERY LAG, RAMPUP COSTS
Defaults Cashflow
BoP Assets BoP Default rate Defaults Recoveries 3M LIBOR Asset WAS Interest rate Assets yielding interest
Interest BoP ManagementRunning
fee costs Liabilities Liability WAC Liability costs Other expenses Income Principal Total
1 30.6.2017 400,00 2,00 % 2,00 - -0,261 % 3,800 % 3,80 % 398,00 - 359,31 1,615 % 1,61 % - 48,32 - 48,32
2 30.9.2017 398,00 2,00 % 1,99 1,40 -0,261 % 3,800 % 3,80 % 396,01 3,78 - 0,500 - 0,070 - 359,31 1,615 % 1,61 % - 1,45 - 1,00 0,76 0,76
3 31.12.2017 397,41 2,00 % 1,99 1,39 -0,199 % 3,800 % 3,80 % 395,42 3,76 - 0,498 - 0,070 - 359,31 1,615 % 1,61 % - 1,45 1,74 1,74
4 31.3.2018 396,82 2,00 % 1,98 1,39 -0,130 % 3,800 % 3,80 % 394,83 3,76 - 0,497 - 0,070 - 359,31 1,615 % 1,61 % - 1,45 1,74 1,74
5 30.6.2018 396,22 2,00 % 1,98 1,39 -0,085 % 3,800 % 3,80 % 394,24 3,75 - 0,496 - 0,069 - 359,31 1,615 % 1,61 % - 1,45 1,73 1,73
6 30.9.2018 395,63 2,00 % 1,98 1,39 -0,022 % 3,800 % 3,80 % 393,65 3,75 - 0,495 - 0,069 - 359,31 1,615 % 1,61 % - 1,45 1,73 1,73
7 31.12.2018 395,04 2,00 % 1,98 1,38 0,038 % 3,800 % 3,84 % 393,06 3,74 - 0,495 - 0,069 - 359,31 1,615 % 1,65 % - 1,45 1,73 1,73
8 31.3.2019 394,45 2,00 % 1,97 1,38 0,102 % 3,800 % 3,90 % 392,48 3,77 - 0,494 - 0,069 - 359,31 1,615 % 1,72 % - 1,48 1,72 1,72
9 30.6.2019 393,86 2,00 % 1,97 1,38 0,170 % 3,800 % 3,97 % 391,89 3,83 - 0,493 - 0,069 - 359,31 1,615 % 1,79 % - 1,54 1,72 1,72
10 30.9.2019 393,27 2,00 % 1,97 1,38 0,229 % 3,800 % 4,03 % 391,30 3,89 - 0,492 - 0,069 - 359,31 1,615 % 1,84 % - 1,60 1,72 1,72
11 31.12.2019 392,68 2,00 % 1,96 1,38 0,287 % 3,800 % 4,09 % 390,72 3,94 - 0,492 - 0,069 - 359,31 1,615 % 1,90 % - 1,66 1,72 1,72
12 31.3.2020 392,10 2,00 % 1,96 1,37 0,351 % 3,800 % 4,15 % 390,14 3,99 - 0,491 - 0,069 - 359,31 1,615 % 1,97 % - 1,71 1,72 1,72
13 30.6.2020 391,51 2,00 % 1,96 1,37 0,414 % 3,800 % 4,21 % 389,55 4,05 - 0,490 - 0,069 - 359,31 1,615 % 2,03 % - 1,77 1,72 1,72
14 30.9.2020 390,92 2,00 % 1,95 1,37 0,474 % 3,800 % 4,27 % 388,97 4,10 - 0,489 - 0,069 - 359,31 1,615 % 2,09 % - 1,82 1,72 1,72
15 31.12.2020 390,34 2,00 % 1,95 1,37 0,532 % 3,800 % 4,33 % 388,39 4,16 - 0,489 - 0,068 - 359,31 1,615 % 2,15 % - 1,88 1,72 1,72
16 31.3.2021 389,76 2,00 % 1,95 1,37 0,610 % 3,800 % 4,41 % 387,81 4,21 - 0,488 - 0,068 - 359,31 1,615 % 2,23 % - 1,93 1,72 1,72
17 30.6.2021 389,17 2,00 % 1,95 1,36 0,689 % 3,800 % 4,49 % 387,23 4,28 - 0,487 - 0,068 - 359,31 1,615 % 2,30 % - 2,00 1,72 1,72
18 30.9.2021 388,59 2,00 % 1,94 1,36 0,751 % 3,800 % 4,55 % 386,65 4,35 - 0,486 - 0,068 - 359,31 1,615 % 2,37 % - 2,07 1,72 1,72
19 31.12.2021 388,01 2,00 % 1,94 1,36 0,813 % 3,800 % 4,61 % 386,07 4,40 - 0,486 - 0,068 - 359,31 1,615 % 2,43 % - 2,13 1,72 1,72
20 31.3.2022 387,43 2,00 % 1,94 1,36 0,880 % 3,800 % 4,68 % 385,49 4,45 - 0,485 - 0,068 - 359,31 1,615 % 2,49 % - 2,18 1,72 1,72
21 30.6.2022 386,85 2,00 % 1,93 1,36 0,947 % 3,800 % 4,75 % 384,92 4,51 - 0,484 - 0,068 - 359,31 1,615 % 2,56 % - 2,24 1,72 1,72
22 30.9.2022 386,27 2,00 % 1,93 1,35 1,009 % 3,800 % 4,81 % 384,34 4,57 - 0,484 - 0,068 - 359,31 1,615 % 2,62 % - 2,30 1,72 1,72
23 31.12.2022 385,70 2,00 % 1,93 1,35 1,069 % 3,800 % 4,87 % 383,77 4,62 - 0,483 - 0,068 - 359,31 1,615 % 2,68 % - 2,36 1,71 1,71
24 31.3.2023 385,12 2,00 % 1,93 1,35 1,130 % 3,800 % 4,93 % 383,19 4,67 - 0,482 - 0,067 - 359,31 1,615 % 2,75 % - 2,41 1,71 1,71
25 30.6.2023 384,54 2,00 % 1,92 1,35 1,191 % 3,800 % 4,99 % 382,62 4,72 - 0,481 - 0,067 - 359,31 1,615 % 2,81 % - 2,47 1,71 1,71
26 30.9.2023 383,97 2,00 % 1,92 1,35 1,251 % 3,800 % 5,05 % 382,05 4,77 - 0,481 - 0,067 - 359,31 1,615 % 2,87 % - 2,52 1,71 1,71
27 31.12.2023 383,40 2,00 % 1,92 1,34 1,309 % 3,800 % 5,11 % 381,48 4,82 - 0,480 - 0,067 - 359,31 1,615 % 2,92 % - 2,57 1,70 1,70
28 31.3.2024 382,82 2,00 % 1,91 1,34 1,380 % 3,800 % 5,18 % 380,91 4,87 - 0,479 - 0,067 - 359,31 1,615 % 2,99 % - 2,63 1,70 1,70
29 30.6.2024 382,25 2,00 % 1,91 1,34 1,452 % 3,800 % 5,25 % 380,34 4,93 - 0,479 - 0,067 - 359,31 1,615 % 3,07 % - 2,69 1,70 22,94 24,64

2,00 % IRR 8,52 %

Recovery lag 2 Interest income lost

in rampup
Recovery rate 70 %
Management fees 0,50 %
Running costs 0,07 %

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PRICING OF RATED NOTES

• Pricing of rated notes is very different from equity pricing

• Key is to assess:

1. Probability of losses exceeding the buffer in the notes

– More generally expected losses in the tranche

2. Required rate of return for the CLO tranche

– Influenced by a large number of factors

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RISKINESS OF RATED NOTES

• Amount of par subordination

– How much losses before the tranche gets hit
• Thickness of the tranche
– How much more losses until all principal of the tranche is lost
• MVOC (Market Value OverCollateralization)
– Tells how much credit enhancement would be left if the CLO
manager sold the portfolio and purchased a new one at 100
• Quality of worst assets in the loan portfolio
– Defaulted already or going to default soon?
– Ratings
– Market price

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RISKINESS OF RATED NOTES (2)

• Structural protections
– OC Tests
– Reinvestment Diversion Test
– Etc.

• Other topics such as:

– Diversity score
– Correlation between loans
– Variability of recovery rates in the portfolio
– Variability of default rates in the portfolio
• E.g. over economic cycle
– Par erosion through buying loans above par
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REQUIRED RATE OF RETURN
• Key components:
1. Expected loss in the tranche; often small, depends on assumptions
2. Volatility premium (BBs are 4x high yield in stress periods)
3. Tranche beta (CAPM; normally highly positive)
4. Illiquidity premium (liquidity is very variable)
5. Duration
6. Weighted average life risk (uncertainty of WAL / duration)
7. Complexity (work required and the chance that you got it wrong)
8. Distribution of returns (are returns capped on the upside)
9. Regulatory treatment / cost (Solvency II)
10. Regulatory and legal risk premium (strength of setup)

• Sometimes different for secondary and primary market

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LIQUIDITY CONSIDERATIONS

• Liquidity / illiquidity for the note

– Investor-based for this CLO manager
– Strength of regulatory setup: Regulatory setup for risk retention
– Amount of unpriced / illiquid assets in the loan portfolio
– Unusual structural features
– Past losses in the portfolio / manager performance
– Other complications in the portfolio

• CLO market exhibits strongly variable liquidity

(sometimes a lot, sometimes none)

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DISCOUNT MARGIN

• CLO tranches are floating rate notes (FRN)

– Their coupon is LIBOR + a spread

• CLO notes can trade at prices ranging from less than 50 to

over 100

• Discount margin is the spread of an FRN trading at 100

that gives the same IRR as the note being analyzed
– LIBOR follows the forward curve
– Enables easy comparison of bonds trading at different prices and
spreads

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DISCOUNT MARGIN (2)

Price 95,00 100,00

Spread 3,5000 % 4,3822 %

Year LIBOR Note Par bond

0 0,50 % - 95,00 - 100,00
1 0,75 % 4,00 4,88
2 1,00 % 4,25 5,13
3 1,25 % 4,50 5,38
4 1,50 % 4,75 5,63
5 1,75 % 5,00 5,88
6 2,00 % 5,25 6,13
7 105,50 106,38

IRR 5,5781 % 5,5781 %

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MARKET LEVELS FOR CLO NOTE DMS
27.11.2017:
US Euro
B 700 690
BB 500 490
BBB 250 245
A 170 165
AA 140 120
AAA 112 75
11.5.2017:
US Euro
B 850 800
BB 675 580
BBB 375 320
A 275 210
AA 200 150
AAA 120 90
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