“You don’t have a lot of envy, you don’t have a lot of resentment, you don’t overspend your income, you stay cheerful in spite of your troubles, you deal with reliable people and you do what you’re supposed to do. All these simple rules work so well to make your life better.” Charlie Munger
CLO Market Musings: Collateral Pool Factors Before Call (Updated)
Based on a sample of 496 post-2012 US CLO deals that have been fully redeemed (excluding deals with debt impairment), the median deal displayed a collateral pool factor of 78% prior to full redemption. Notably, among these deals, 75% had a collateral pool factor of at least 50%, while 25% surpassed 98%.
|Colalteral Pool Factors before Call
This data is interesting. It suggests that CLO debt at inception might be modeled more conservatively than necessary. Generally, CLO debt tranches are modeled to run to maturity based on specified prepayment rates. Therefore, if a deal experiences higher prepayment rates, it would delever more quickly and could be called much earlier than expected. Consequently, if the yield term structure is upward-sloping, debt investors might receive a wider spread for a shorter-than-anticipated deal duration. Moreover, if the primary CLO debt tranche is priced at a discount, this would lead to debt investors benefiting from additional spreads.
For CLO equity investors, modeling a deal to maturity is understandable due to the difficulties in predicting remaining portfolio prices upon redemption. For debt holders, the situation is presumably more straightforward, as they are repaid at par upon redemption, even when certain portfolio price assumptions are applied in their base case scenario.
Why Does the Collateral Pool Factor Matter?
A collateral pool experiencing rapid prepayment rates, particularly in the first one to two years after the reinvestment end-date, can significantly reduce the CLO’s leveraged structure. This scenario, coupled with an increased cost of funding as the AAA tranche is retired first, greatly increases the likelihood of full redemption by equity holders. The combination of reduced structural leverage within the CLO and a higher cost of funding can have a significant negative impact on the equity distribution.
For example, among 118 deals with a collateral pool factor below 50% before full redemption, the average final equity distribution was only around 0.8%.
More information about suggested assumptions on prepayment rates for US BSL CLOs, US MM CLOs, and EU CLOs can be found in CLO Research’s recent freemium report Suggested Post-RI Prepayment Rates for CLO Cash Flow Modelling.
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The information, research, data, research-related opinions, observations, and estimates contained in this document have been compiled or arrived at by CLO Research Group, based upon sources believed to be reliable and accurate, and in good faith, but in each case without further investigation. None of CLO Research Group or its service providers; authorised personnel, or their directors make any expressed or implied presentation or warranty, nor do any of such persons accept any responsibility or liability as to the accuracy, timeliness, completeness, or correctness of such sources and the information, research, data, research related opinions, observations and estimates contained in this document. All information, research, data, research-related opinions, observations, and estimates in this document are in draft form as of the date of this document and remain subject to change and amendment without notice. Neither CLO Research Group nor any of their third-party providers shall be subject to any damages or liability for any errors, omissions, incompleteness, or incorrectness of this document. This article is not and should not be construed as an offer, or a solicitation of an offer, to buy or sell securities and shall not be relied upon as a promise or representation regarding the historical or current position or performance of any of the deals or issues mentioned in it.