“The wind blows the roof tile; the tile falls on my head; I don’t blame this tile; this tile is not free.”
CLO managers are fully aware that investors have access to an abundant amount of databases, including daily underlying portfolio loan prices. It is undoubtedly positive as both CLO (Collateralised Loan Obligation) managers and investors can be more upfront about specific challenging issues if any – no one likes surprises.
Forget about the unicorn! One could spend lots of time on top underlying exposures, credit ratings, WARF, D-score, cov-lite, second-lien, Caa buckets, weight average spreads, maturity but if one does not know the market prices of the underlying CLO loan collateral – is it akin to one shooting arrows into the air? Capital preservation is the top priority for doing all the due diligence work. Having said that, running a lower-spread CLO collateral pool does not necessarily mean that it is of a higher quality!
Besides the general market conditions, CLO debt tranches are usually differentiated by their market value overcollateralisation ratios (MVOCs), among other factors such as new issue spreads, duration, manager perception (debt or equity friendly, tiering), refinancing and reset options. What about the documentation languages? If some terms are too restrictive, there is more incentive for CLO equity holders and managers to restructure the whole deal (debt repaid) if economics makes sense. Senior debt investors probably focus most of their time on documentation languages making sure their senior interest is fully protected. They are more worried of a rating downgrade given the higher capital charge.
Has the market become too short-sighted by giving too much attention to the underlying loan price movement? Some might argue that CLO is ultimately not a ‘mark-to-market (MTM)’ vehicle unless Caa bucket breaches the threshold, which makes part of the portfolio become ‘MTM’. Besides, the stark reality is – how many CLOs mature on legal maturity date? Most deals would be redeemed or rolled into new deals before their maturity dates unless rated debt cannot be made whole upon redemption.
Going beyond the Caa threshold (averaging 7.5%) is akin to queue-jumping in the UK – certainly not something one is proud of. On the other hand, CLO managers might reluctantly choose to crystallise losses by trading out of some better-priced Caa loans or other B-rated loans that are about to be downgraded to Caa. Hence it is essential to look at trading losses too. If some of the Caa names trade well, it gives flexibility to managers to maintain a lower Caa bucket without taking too much of a hit. Note that the excess lowest-priced Caa names would become MTM instead of being treated at par for the calculation of OC ratios. From a senior tranche holder’s perspective, CLO managers who did well on MTM would have more flexibility to manage credit rating migration.
Another interesting observation is that “below 80” loan bucket is worth tracking. It could also explain the volatility experienced in CLO tranche prices, especially at the equity and lower mezzanine level. It is not uncommon to see market participants assuming a default on those loans when they are pricing CLO equity. While investing in CLO equity can be very risky, it is rewarding if CLO managers can consistently avoid those problematic credits and deliver good loan collateral return.
From the CLO equity standpoint, CLO structure is a funding structure, so its performance would depend on the total return of the underlying collateral – preferably, a more substantial part of the total return outperformance comes from interest outperformance. One can extract more colour if the underlying loan collateral return performance (with performance attribution) is compared to loan index and peers adjusting for vintage.
Ranking CLO manager performance based on CLO equity cashflows has many flaws due to factors such as different structural leverage, interest reserve, and class X. Ranking performance based on MVOC or CLO Equity NAV is not ideal as it has different opening levels, omitted the interest component, among others.
To conclude, bankers like to watch cashflows closely. Perhaps CLO participants should watch the underlying loan collateral return performance (with performance attribution) relative to index and peers?
(Poh-Heng Tan is the Managing Director with CLO Research Group based in London)
