By Sunil K Parameswaran
Collateralised Loan Obligations (CLOs) are securities backed by a diverse pool of senior secured loans. The portfolio consists primarily of first lien senior secured loans. CLOs are funded by debt of varying seniority and equity. The principal and interest is distributed according to a Cash Flow Waterfall.
The debt obligations have varying seniority in the waterfall. Residual cash flows go to the CLOs equity. For equity holders to get a return, interest income from loan portfolio must exceed the interest expense of the CLO’s debt obligations.
Senior secured loans are also known as leveraged loans. They are loans to companies rated below investment grade. They typically have a first priority lien and rank ahead of unsecured debt. These are high risk loans, made to borrowers who have a lot of debt, and/or poor credit. Interest rates are high due to a greater risk of default.
The proceeds from the issuance of CLO debt obligations and equity, is used to purchase the collateral. Each class of CLO debt has a different priority on cash flow distributions and different loss exposure. Cash flow distributions begin with the senior most class and flow down to equity.
Senior debt represents the least risky debt obligations. They carry the lowest coupon. They are typically rated AAA or AA. They are usually not deferrable, that is, missing an interest payment will tantamount to default. Mezzanine debt is less risky than senior debt, and consequently carries higher coupons. Equity represents a claim on all excess cash flow once the obligations for each debt tranche have been met. This is the first loss position.
Cash flows from the portfolio are used to make payments to different classes of debt and equity. Cash flow entitlements are top down, while losses on collateral are bottom up. A debt tranche with a given level of seniority plus will receive full interest and principal due, before any payments are made to the next tier. On payment dates the structure must achieve performance-based tests. To pass it, the principal value of the underlying collateral must exceed the principal value of the tranche, by a predetermined minimum ratio. Failure would imply redirecting flow of funds to achieve this level, which would preclude payments to lower rated tranches.
All tranches rely on the same collateral pool. But junior tranches absorb losses before the senior tranches. The par value of a CLO’s assets is greater than the par value of its debt obligations. The additional collateral is funded by equity.
The difference between the income from the portfolio over the interest due on the debt tranches is called excess interest. To ensure that adequate funds are generated for making timely interest payment, there will be an Interest Coverage (I/C) ratio. That is, the income from the underlying investments must be greater than the interest due on outstanding debt.
Tests are used to regularly detect warning signs of deterioration in the value of collateral. If the collateral performance deteriorates cash flows are redirected from junior tranches, to purchase additional collateral, and repay the most senior tranche.
The writer is CEO, Tarheel Consultancy Services