Virtue is bold, and goodness never fearful. – William Shakespeare
In the CLO market, the terms “CLO performance” and “resilience” can have varying definitions. It’s crucial to acknowledge that a CLO may underperform even if its deal metrics appear resilient. In addition, the term ‘resilience’ is typically used to describe the performance of CLO debt rather than CLO equity performance.
CLOs are primarily actively managed, and some commonly used deal metrics—point-in-time indicators—can occasionally be misleading. While these metrics can be useful, they should not be considered in isolation. Additionally, combining multiple metrics does not necessarily provide a clearer picture. For example, the weighted average price (WAP) of a CLO portfolio does not measure return performance over time and can be artificially inflated by trading activity. Though WAP is helpful for quick screening, it is not a reliable indicator of whether one manager has outperformed another. The same applies to annual equity distributions—a higher distribution does not necessarily indicate better manager performance. Therefore, combining these two metrics does not necessarily offer a more accurate assessment of a manager’s performance.
The primary objective of CLO managers is to deliver investment returns; their focus is on achieving this goal rather than merely showcasing impressive deal metrics.
Annualised CLO equity payments
While this metric is useful on its own, its effectiveness diminishes when used to compare different deals and CLO managers, due to the long list of factors outlined below:
- Structural differences (different leverage ratio)
- Par flush
- First period interest reserve amount variation
- Class X issuance
- Release of capital upon reset
- Funding of delayed-issuance tranche
- Insertion of a single-B tranche upon a full refinancing
- Transfer to a collateral enhancement account (more common in EU CLOs)
- Transfer of trading gains to interest account (for risk retention compliance)
- Amortisation of the lower mezz tranche using interest proceeds
- Stub payment
- Reinvestment of equity payments
- Different management fee structures
- Different incentive fee structures
The first payment distribution can also go up if there is a “par flush,” if the first period interest reserve account is bigger, or if there is a “stub payment,” which is paid for by a higher primary CLO equity price. On the other hand, equity cashflows are artificially reduced during the class x amortisation period (say, around 2 years) as the class X tranche is paid out of the interest account (even ahead of the AAA tranche).
One important question investors should ask is how much of the annual distributions are derived from the principal account.
Besides, this metric does not capture the MV health of the collateral pool. In summary, an above-average annualised CLO equity distribution does not mean that a deal’s arbitrage is good. Similarly, a lower yielding CLO equity does not necessarily mean that its arbitrage is poor. Further, this metric does not capture different market conditions at the time of issuance
2.0 CLOs typically rely on the final equity Net Asset Values (NAVs) to deliver strong overall returns. In contrast, 1.0 CLOs depended on high cash-on-cash distributions. To gain a deeper understanding of the differences, reading the article titled ‘Some Reflections on the Drivers of 1.0 US CLO Equity Outperformance‘ is recommended.
Equity notional: Do dealers charge based on equity notional or the market value (MV) of the tranche? If dealers charge fees based on equity notional for distribution or trading, it might be better to structure a deal with normalized equity notional rather than having a large notional at a lower price. Therefore, generally speaking, equity distributions are still useful to some extent. That said, when combined with CLO Equity NAV, it offers a better measure of a deal’s performance from an equity standpoint. Comparing managers’ performance solely based on distributions and NAV is much more nuanced. As mentioned earlier, different structural features, management fees, and other variables can skew this performance metric. Hence, at CLO Research, we assess managers based on their underlying collateral return performance relative to the relevant loan index, which better captures their credit skills.
MVOC and CLO Equity NAV
Market Value Over-Collateralisation (MVOC), for instance, at the BB tranche level, is calculated by dividing the collateral MV by the sum of CLO liabilities (AAA to BB). Primary and secondary market participants focus a lot on this number – a point in time metric – as it is an important metric for pricing CLO-rated tranches. Put another way, CLO-rated tranches do trade on the back of the loan market.
That said, a deal might have a different opening level due to varying leverage in the capital structure. A CLO capital structure is a function of key factors such as the portfolio initial weighted average life limit, WARF, and diversity score. In other words, the inherent leverage within the CLO capital structure is driven by these factors.
The MVOC metric also ignores par distribution, which should be considered part of the overall manager’s performance. Some managers could deliver a higher carry without compromising on their MVOC. That said, MVOC remains a very important metric for debt investors.
CLO Equity NAV does not mean a third-party valuation of a CLO equity tranche. Rather it means the ‘liquidation value’ of the equity tranche. Basically, CLO Equity NAV is calculated by dividing the residual collateral value (MV collateral net of total CLO debt notional) by the equity tranche notional.
It is a useful metric as it is easily understood. This metric also magnifies and highlights any change in equity NAV, even when the collateral market value moves slightly. For a post-2012 CLO deal to deliver a decent equity IRR, the final NAV realisation plays a key role.
Still, the different opening levels (which could vary quite a bit due to different leverage ratios) and class X or single-B rated tranches would make the comparison between deals and managers tricky.
Both metrics ignore the generation of collateral pool interest, which is part of the total return equation. Further, they do not really capture different market conditions at the time of issuance. MVOC is not a return metric.
Historical CCC and default experiences
Managers could improve the portfolio by trading out of near-CCC or CCC-rated assets. In fact, some managers have achieved good results despite their deals containing a larger proportion of CCC-rated assets. Defaulted assets could be restructured, or distressed assets could be sold, which would artificially minimise the holdings of defaulted assets.
Please note that the defaulted asset holdings reported in CLO monthly trustee reports are not the same as the 1-year speculative default rate.
Managers have the option to improve the portfolio by trading out positions close to or rated CCC. Defaulted assets could be either restructured or sold, leading to their removal from the defaulted category.
Weighted Average Price (WAP)
How useful is this metric? It is undoubtedly helpful for a quick assessment of the collateral credit risk, but it has some limitations. The WAP metric is a point-in-time metric, so it does not really measure return performance over a period of time. WAP could be artificially inflated due to trading. CLO Managers could have crystallised portfolio losses by trading out of poorly performing assets. On the other hand, some managers might have built quality par, which could help soften the negative MTM impact. Be that as it may, the quality of each portfolio varies from one deal to another.
One has to look at the entirety of the manager’s performance since inception, including the interest performance component and adjustments for the different market conditions.
Breakeven CDR
CDR means constant default rate – the effective annual default rate applied to the beginning CLO collateral balance for each period (on a monthly basis). 2% refers to the annual figure so the monthly default rate would be 2%/12 = 0.1667% per month.
Breakeven CDR refers to the CDR that will lead to the first write-down of a rated tranche. Typically this scenario will see a low prepayment rate and recovery rate. It is also fair to assume a lower reinvestment loan price.
While it is a useful metric, it could make the comparison between tranches difficult due to the different capital structural leverage, which is a function of the reinvestment period, the initial weighted average life limit, WARF, and diversity score. This metric also does not say much at all about the underlying collateral performance. Sometimes, the linear default rate assumption might have given too much credit to the soft credit support – i.e. excess spread diversion to support the rated tranches.
WAS
The term WAS, or Weighted Average Spread, refers to a key metric used to assess the risk associated with the underlying collateral of a CLO. In general, a higher WAS may indicate a riskier collateral pool, as some CLO managers may seek higher-yielding but potentially riskier investments to achieve arbitrage. However, it is important to note that a higher WAS does not necessarily mean that the collateral pool is riskier.
There are CLO managers who run a higher WAS portfolio but show resilient market value return performance over their peers with a lower WAS portfolio. As such, while WAS can be a useful tool for assessing risk, it should not be the only factor considered.
WARF
What is WARF? WARF is the acronym for Moody’s Weighted Average Rating Factor. A portfolio WARF of 2,700 indicates an idealised 10-year default probability of 27.0%. While one should not take it in a literal sense, it is informative given the consistency involved. Changes in the WARF could provide more information. While WARF is useful, a lower WARF might not translate to a better investment performance relative to the loan index. Similarly, a higher WARF might not necessarily translate to poorer investment performance. Further, trading out of more distressed names could artificially lower the WARF. All said deals might not have the same trustee reporting dates, which can make comparison difficult.
Relying on a rating agency’s WARF only might not give the fuller picture as a deal is normally rated by at least two rating agencies.
Annualised par build
Managers might have built par by buying a loan at 85c (treated at par for OC ratio calculation). That said, if that loan were to trade down to say 60c, would one still see it as a ‘true’ par-building trade? Guess it is not a surprise that annualised par build numbers do not necessarily translate to good investment performance. Further. distressed assets could be shown at par value for a period of time.
An annualised par build metric does not say much about the quality of the par build and realised or unrealised MV gains/losses. As with MVOC, it does not capture the income return of a portfolio.
Analyzing Price Buckets Below 80/70/60 for CLO Underlying Collateral
Tracking price buckets at 80/70/60 or below for CLO underlying collateral can be useful in assessing tail risk in the asset pool. Among these price buckets, those at 60 or below can be particularly valuable in identifying assets that are truly distressed. However, it’s still important to consider the impact of trading activity on these buckets, as CLO managers may have traded out of distressed assets to crystallize portfolio losses. Therefore, it’s important to evaluate a manager’s performance as a whole.
Interest diversion and OC tests
Changes in the test cushions can be useful in highlighting underperforming deals in general, but one needs to be mindful that some deals have their tests set with tighter cushions. OC cushions are perhaps less useful in determining better-performing deals. The breaching of ID/OC tests could be driven by the excess CCC bucket (and the average price on the excess lowest-priced CCC bucket), as well as losses due to defaults and trading. Typically, deals that have breached their OC tests are deals that have underperformed. One also needs to understand the health of the more significant part of the portfolio.
Liquidity
What about collateral pool liquidity? Some managers advocate a strategy of adding more smaller loan facilities but would that translate to better investment performance? Based on CLO Research’s previous findings, it is hard to draw any conclusion about the relationship between investment performance and liquidity measure.
Trading Volume
Is there any relationship between trading volume and investment performance? Again, it depends on the timing and the quality of trades.
In conclusion, it is important to understand the limitations of each metric so as to avoid mistaking outperformance of deal metrics to be investment outperformance.
For more information on how CLO research can assist you in navigating the complexities of the CLO market, we invite you to explore the page “Why CLO Research Group“.
Dealscribe and CLO Research have collaborated to develop a comprehensive guide tailored for CLO equity investors. Eligible financial market professionals may request a copy of the report here.
Disclaimers
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.
