CHAPTER
THIRTY-FIVE
COLLATERALIZED LOAN OBLIGATIONS

FRANK J. FABOZZI, PH.D., CFA, CPA

Professor of Finance
EDHEC Business School

A collateralized debt obligation (CDO) is a structured financial product backed by a diversified pool of one or more types of debt obligations. The pool is usually managed by an asset manager. A CDO issues debt and equity and utilizes the proceeds received to acquire a portfolio of debt obligations. The cash-flows from the pool of debt obligations are distributed to the holders of the CDO’s various liabilities in prescribed ways that take into account the relative seniority of those liabilities.

Issuance of CDOs backed by pools of corporate bonds, residential mortgage-backed securities, commercial mortgage-backed securities, and asset-backed securities has ceased, and few market observers believe these types of CDOs will be issued in the future. A CDO backed by a pool of bank loans is called a collateralized loan obligation (CLO). This type of CDO continues to be issued and is the subject of this chapter.

The terminology regarding what is a CLO can be confusing. A CLO is a distinct legal entity that, as explained later, is established as a bankruptcy-remote entity and is the issuer of the securities that investors can purchase.¹ The confusion is that the CLO is both the issuer of securities and the securities issued are also referred to as CLOs. That is, a CLO can mean the issuer and the securities issued by the CLO. The context in which CLO is used in the chapter will make it clear how the term is used.

There are four key attributes of a CLO: assets, capital structure, purpose for creation, and credit structure. We briefly describe each in this chapter.²

ASSETS

The assets of a CLO are corporate loans, most always performing leveraged loans. As explained in Chapter 13, leveraged bank loans are loans to corporations with a speculative-grade rating. But some CLOs have been backed by pools of defaulted and distressed loans and some have been backed by a pool of investment-grade loans. Instead of buying loans, some CLOs have gained exposure to loans by selling credit protection on loans or loan obligors via credit default swaps. In these transactions, the CLO obligates itself to pay what is essentially the credit loss associated with a default of a loan.

CAPITAL STRUCTURE

A CLO’s capital structure includes senior debt, mezzanine debt, subordinated debt, and equity. The securities issued by a CLO are commonly referred to as tranches and labeled in an offering as Class A, Class B, Class C, and so forth going from top (in terms of payment seniority) to the bottom of the capital structure. They range from the most secured triple A rated tranche with the greatest amount of subordination beneath it, to the most levered, unrated equity tranche. A simplified tranche structure for a CLO backed by a pool of leveraged loans is shown in Exhibit 35–1.

EXHIBIT 35–1
Simple, Typical CLO Tranche Structure

A CLO is created so as to be a “bankrupt remote entity,” and this is accomplished by establishing a special purpose entity (SPE) that affords that protection. A very important aspect of a CLO’s bankruptcy remoteness is the absolute seniority and subordination of the CLO’s debt tranches to one another. Even if it is a certainty that some holders of the CLO’s debt will not receive their full principal and interest, cash-flows from the CLO’s assets are still distributed according to the distribution rules dictated by seniority. The CLO cannot go into bankruptcy, either voluntarily or through the action of an aggrieved creditor. In fact, the need for bankruptcy is obviated because the distribution of the CLO’s cash-flows, even if the CLO is insolvent, has already been determined in detail at the origination of the CLO. But within the stipulation of strict seniority, there is great variety in the features of CLO debt tranches. The driving force in creating a CLO structure is to raise funds at the lowest possible cost. This is done so that the CLO’s equity holder, who is at the bottom of the chain of seniority, can get the most residual cash-flow.

CREATION PURPOSE

CLOs are created for one of two purposes: balance sheet or arbitrage. The latter is the more common purpose.

In the case of a balance sheet CLO, the bank sells loans to a CLO for one or more of the following reasons: (1) reduce the size of its balance sheet, (2) reduce required regulatory capital, (3) reduce required economic capital, or (4) achieve cheaper funding costs. Selling the loans to a CLO removes them from the bank’s balance sheet and therefore lowers the bank’s regulatory capital requirements. This is true even if the bank is required to buy some of the equity of the newly created CLO.

The motivation for an arbitrage CLO is that an asset manager specializing in loans seeks to augment assets under management and management fees. It is the asset manager who assembles the initial portfolio of an arbitrage CLO and manages it according to prescribed guidelines set forth in the CLO’s indenture. Investors wish to have the expertise of an asset manager specializing in leveraged loan portfolio management. Loans are purchased in the marketplace by the asset manager from many different sellers and put into the CLO. CLOs are another means, along with mutual funds and hedge funds, for an asset manager to provide a service to investors. The difference is that instead of all the investors sharing the fund’s return in proportion to their investment, investor returns are also determined by the seniority of the CLO tranches they purchase.

These two purposes differentiate CLOs on the basis of how loans are acquired, the motivation for banks to sell loans, and the motivation of asset managers. From the perspective of CLO investors, all CLOs have a number of common purposes. One such purpose is the partitioning and allocation of the credit risk of the pool of loans among investor groups that have different risk appetites. Thus, both a triple A investor and a double B investor can invest in leveraged loans. Often, CLO debt provides a higher spread than comparable investments.

For the equity investor, a CLO provides a leveraged return on a diversified portfolio of leveraged loans without the need to obtain borrowing via repurchase agreements (repos) from a bank. It allows the investor to obtain nonrecourse long-term financing at a fixed spread to LIBOR. The equity investor in a CLO consequently has placed a loss limit equal to the cost of purchasing the equity tranche reduced by the prior distribution of cash from the CLO.

CREDIT STRUCTURES

CLOs have additional structural credit protections beyond the protection afforded by seniority and subordination of the CLO’s capital structure. These credit structures fall into the category of either cash-flow or market value protections. We will only discuss the cash-flow credit structure here because it is the dominant credit enhancement mechanism in CLOs, being roughly 95% of all CLOs. The specifics of a CLO’s cash-flow structure determine the risks taken on by various classes of CLO debt and equity and therefore the return profiles of those classes.

It is necessary to understand a CLO’s cash-flow waterfalls in order to understand the cash-flow credit structure. There are two waterfalls in a cashflow CLO: one for collateral interest and another for collateral principal. It is the cash-flow waterfalls that dictate the payment priority to the holders of the CLO tranches and thus enforce the seniority of one creditor in the structure over another. The cash-flow waterfalls specify coverage tests and the failure of such tests can result in the diversion of collateral cash-flow from subordinated CLO creditors to senior CLO creditors. The most important of these are the par coverage tests:

Class A Par Coverage Test = Asset Par/Class A Par
Class B Par Coverage Test = Asset Par/(Class A Par + Class B Par)
and so on, for all of the CLO debt tranches

The par of defaulted loans is reduced or excluded from Asset Par in the numerator of par coverage tests.

Here is a simple, typical interest waterfall in which collateral interest is applied to CLO creditors in the following order:

1. To the trustee for base fees and expenses

2. To the asset manager for base fees

3. To Class A for interest expense

4. If Class A coverage tests are failed, to Class A for principal repayment until Class A coverage tests are met

5. To Class B for interest expense

6. If Class B coverage tests are failed, to the senior-most outstanding tranche (which could be Class A or, if Class A has been paid in full, Class B) for principal repayment until Class B coverage tests are met

7. To Class C for interest expense

8. If Class C coverage tests are failed, to the senior-most outstanding tranche for principal repayment until Class C coverage tests are met
(Steps 7 and 8 are repeated for remaining debt tranches)

9. An additional coverage test that determines whether an amount of collateral interest must be reinvested in additional collateral

10. Additional fees to the trustee

11. Additional fees to the asset manager

12. To the equity tranche, in accordance with any profit sharing agreement with the asset manager

Note that coverage tests force a decision to be made about whether to pay interest to a class or pay down principal on the senior-most outstanding class.

Here is a simple, typical principal waterfall in which collateral principal is applied to CLO creditors in the following order:

1. Amounts due in 1 through 8 of the interest waterfall that were not met with collateral interest

2. During the CLO’s reinvestment period, to purchase new collateral assets

3. After the reinvestment period, for principal repayment of tranches in order of their priority

4. Amounts due in 9 through 12 of the interest waterfall

The purpose of the diversion of collateral interest is to provide greater protection to senior CLO tranches. The CLO’s debt tranches can receive all their principal and interest even if collateral losses exceed the amount of subordination below them in the capital structure. The benefit of coverage tests to senior tranches depends on how soon the tests are breeched. The earlier the diversion of interest to senior tranches occurs, the greater is the collateral interest diverted over the remaining life of the collateral. The amount of cash that can be diverted is smaller if tests fail late in the CLO’s life.

However, there are strategies that a CLO manager can employ to circumvent the protection of cash-flow diversion. “Par building” trades artificially improve par coverage tests by replacing relatively high price collateral with relatively low price collateral. For example, suppose that a CLO manager sells $6 million of loans at par and with the proceeds from the sale acquires $7 million par of loans selling at 85%. This action would inflate Asset Par by $1 million in the numerator of the par coverage test. Done in enough size, it could prevent a CLO from violating par coverage tests and keep cash flowing down the CLO’s waterfall to the manager and equity holders.

KEY POINTS

• A CLO is a type of CDO in which the pool of assets consists of bank loans, typically leveraged loans.

• A CLO’s capital structure includes senior debt, mezzanine debt, subordinated debt, and equity.

• CLOs are created for one of two purposes: balance sheet or arbitrage. Regardless of the purpose for the creation of a CLO, from a CLO investor’s perspective the purpose is the partitioning and allocation of the credit risk of the pool of loans among investor groups that have different risk appetites.

• In addition to the protection afforded by seniority and subordination of the CLO’s capital structure, there is another structural credit protection that allows the diversion of cash-flow to the senior-most tranche outstanding if prescribed coverage tests are not satisfied.