Credit · C10 · 9 min

CLOs: collateralised loan obligations

See how a pool of risky loans is turned into safe and risky bonds, and run the tests that protect the safest ones.

In the news: “CLO managers are buying loans again”: these funds buy many leveraged loans, so their appetite moves loan prices.

The essentials

Collateralised loan obligation (CLO): A vehicle that buys a pool of a couple of hundred and pays for them by selling notes. A manager picks and trades the loans; a trustee collects their cash and pays the notes in order.
Tranches and subordination: The notes are slices paid in order: AAA, AA, A, BBB, BB, then equity. Cash flows from the top and losses from the bottom, so the slices beneath are a cushion: in an illustrative $500m CLO, 38% must be lost before $310m of AAA is hit.
OC and IC tests: Quarterly checks that must stay above set triggers. The divides the loans’ face value by the notes from AAA down to a slice: $500m against $425m is 117.6%. The does the same for interest.
When a test fails: Cash meant for the lower slices and the equity repays AAA notes instead, until the ratio is restored. Defaults lower the ratios, and so do downgrades: CCC loans above a set limit count at market value, not face value.
The reinvestment period: A CLO is assembled in a warehouse, then for its first few years the manager uses money from repaid loans to buy new ones. After that, repayments pay off the AAA notes first and the deal shrinks.

The OC test

OC = loans’ face value ÷ notes from AAA down to the slice

OC: overcollateralisation ratio: it must stay above the slice’s trigger
notes: the face value of the slice and every slice above it

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How it works

1. Pooling loans

Take 200 , worth $500m in all. A (collateralised loan obligation) buys them and pays for them by selling its own bonds, called notes, to investors. The interest and repayments on the loans pay the notes.

2. Slices paid in order

The notes come in , slices paid in a set order: AAA first, then AA, A, BBB, BB, and the equity last. Cash is paid from the top down; losses are taken from the bottom up.

3. Why the AAA is safe

In an illustrative $500m CLO with $310m of AAA notes, $190m of other slices sit underneath. Losses must use up all of that, 38% of the pool, before the AAA loses anything. That cushion is called subordination.

4. Losses each year

The pool’s loss each year ≈ default rate × (1 − recovery). If 3% of loans default and recover 60%, the pool loses about 1.2% a year. Over five years that is about 6%: painful for an equity slice of 10%, but nowhere near the AAA.

5. The OC test

CLOs check their cushion every quarter. The divides the loans’ face value by the notes from AAA down to a given slice: $500m ÷ $425m of AAA-to-BBB notes = 117.6%. Each slice’s test has a minimum, its trigger.

6. When a test fails

Defaults lower the loans’ face value, and so do downgrades, because loans rated CCC above a set limit count at market value. If a ratio falls below its trigger, cash meant for the lower slices and the equity repays AAA notes instead, until the notes fall to the loans’ face value ÷ the trigger.

7. Excess spread and the IC test

The loans pay more interest than the notes cost, and the surplus, the , normally goes to the equity. The checks that interest collected comfortably covers interest due, just as the OC test does for face value.

8. The life of a CLO

A CLO starts in a warehouse, a bank loan used to buy loans before the notes are sold. For the first few years, the , the manager uses repaid money to buy new loans. After that, repayments pay off the AAA first. Once a year or two has passed, the equity can replace the notes with cheaper ones.

Worked example

An illustrative $500m CLO: AAA $310m, AA $55m, A $30m, BBB $30m, BB $25m and $50m of equity. The BBB trigger is 112%. In a year, 4% of the loans default and recover 60%, and CCC downgrades take off another $5m.

Starting BBB OC: 500 ÷ (310 + 55 + 30 + 30) = 500 ÷ 425 = 117.6%.
Default losses: $500m × 4% × (1 − 60%) = $8m.
With the downgrades, the loans count as $500m − $8m − $5m = $487m.
New BBB OC: 487 ÷ 425 = 114.6%, above 112%: cash flows as normal.
The test fails below 425 × 1.12 = $476m, about $11m further down.

The BBB OC falls from 117.6% to 114.6%: it passes, with about $11m to spare before cash is diverted.

Check yourself

8 quick questions on the explanation above.

Practice

New numbers every set. Misses and guesses go into your review deck.

In the interview

Answer out loud in under a minute, then compare.

What is a CLO, in under a minute?
Why would an insurer buy a AAA CLO tranche instead of loans?
What happens when an OC test fails?

Remember

OC = loans’ face value ÷ notes down to the slice

A CLO pays its notes from the top and takes losses from the bottom; when a test fails, cash is redirected to protect the AAA.

Next · C11Mortgage-backed securities I: prepayment