COLLATERALIZED LOAN OBLIGATIONS (CLO) 4.12.2017 Dr. Janne Gustafsson
OUTLINE 1. Structured Credit 2. Collateralized Loan Obligations (CLOs) 3. Pricing of CLO tranches 2
3 Structured Credit
WHAT IS STRUCTURED CREDIT? Structured credit investments are bonds issued by a special purpose vehicle (SPV) Corporation set up solely for the purposes of securitization Bonds are ordered in a priority of payments Most senior gets paid first, junior-most last SPV uses the money raised by selling the bonds to purchase a portfolio of investments + pay setup fees SPV distributes all income (interest etc.) in the order of priority to the bonds (unless reinvested) 4
Collateral Colalteral Risk increases SIMPLIFIED STRUCTURED CREDIT INVESTMENT Collateral 150 MM Collateral 1 50MM Investment portfolio: 75MM Investment 1 25MM Bonds 78MM Senior-most Senior mezzanine AAA: L+90 AA: L+150 Collateral 2 100MM Investment 2 50MM Mezzanine Junior mezzanine A: L+225 BBB: L+350 Issuer SPV Junior-most NR: Rest 5
TERMINOLOGY: TRANCHES Each priority class of bonds is called a tranche Bonds are also often referred to as notes Most-senior tranche is often labeled A note, second-mostsenior B note, etc. Junior-most tranche is called a subordinated note, or equity tranche Equity tranche is still a bond; the actual equity of the SPV is normally held by a charitable trust Other tranches are colloquially referred to by their rating For example, AAA tranche = A note, AA tranche = B note, 6
Collateral Colalteral Risk increases SIMPLIFIED STRUCTURED CREDIT INVESTMENT Collateral 150 MM Collateral 1 50MM Collateral 2 100MM Investment portfolio: 75MM Investment 1 25MM Investment 2 50MM Issuer SPV Bonds 78MM A Note (60%) 46,8MM B Note (15%) C Note (10%) D Note (5%) Sub Note (10%) AAA: L+90 AA: L+150 A: L+225 BBB: L+350 NR: Rest 7
CLASSIFICATION OF STRUCTURED CREDIT INSTRUMENTS Structured credit instruments can be classified based on what kind of investments they hold Leveraged loans (BB-CCC-rated corporate loans) CLO (Collateralized Loan Obligation) Residential mortgages RMBS (Residential Mortgage Backed Security) Commercial mortgages CMBS (Commercial Mortgage Backed Security) Assets ABS (Asset Backed Security) Number of instruments bought by the SPV can vary widely 8 CLO: 100+ loans CMBS: 1-5+ loans (but possibly 100+ properties as collateral) RMBS: 1000+ mortgages and properties as collateral
CLASSIFICATION OF STRUCTURED CREDIT INSTRUMENTS (2) Certain types of structured credit investments are actively managed, in particular CLOs CLO manager can buy and sell loans Portfolio changes over time Requires the existence of an actively traded asset market CLO resembles an active fund investing in leveraged loans CMBS, RMBS, and ABS are typically static Initial investment portfolio does not change Selected by the arranger of the investment (e.g. investment bank) 9
10 Collateralized Loan Obligations
OVERVIEW OF COLLATERALIZED LOAN OBLIGATIONS Contains typically 100-300 loans Typically 90%+ 1st lien, senior secured leveraged loans Loans are typically broadly syndicated Market priced, large corporations, liquid, wide range of loan investors Actively managed by a CLO manager Buys the loans from the loan market at the start Can reinvest during the reinvestment period, and limited ability after the reinvestment period (normally 4 years) Can be called after a non-call period (normally 2 years) 11
Buys and sells Collateral Collateral Risk increases SAMPLE CLO Companies and collateral 800MM Company 1 (BB-): Collateral 8MM Company 2 (B+): Collateral 8MM (total 100 companies) Investment portfolio: Loans: L+380 400MM Loan 1 4MM Loan 2 4MM (total 100 loans) Issuer SPV Issues bonds Tranches: L+161 413MM A Note(60%) 248MM B Note (9%) C Note (6%) D Note (5%) E Note (7%) Sub Note (13%) (rated tranches only) AAA: L+90 AA: L+150 A: L+225 BBB: L+350 BB: L+600 NR: Rest CLO Manager 12
KEY ELEMENTS IN A CLO 1. Loan portfolio Quality and mix of loans 2. Structural protections and features Triggers and trigger levels Reinvestment criteria such as Weighted Average Life Test 3. CLO manager quality and style Ability to trade, avoidance of defaults, high returns, style 4. Commercial topics 13 Management fee, setup costs Purchase price of notes
1. LOAN PORTFOLIO CLO portfolio can contain many kinds of loans and bonds Senior secured 1st lien loans (leveraged loans) 2nd lien loans Senior unsecured loans Junior unsecured (mezzanine) loans Senior secured floating rate notes (bonds) Senior unsecured floating rate notes (bonds) Senior secured fixed-rated bonds High yield bonds (subordinated unsecured bonds) Normally no structured credit or synthetic securities 14
PORTFOLIO STATISTICS Ratings vary normally from CCC to BB Average rating is measured by Weighted Average Rating Factor (WARF) Also the tail loan quality is important, not just the average Market value of loans is normally close to 100 Loan price distribution is an important indicator of default risk E.g., share of loans priced <70, <80, <90 Some loans are unpriced Risk analysis more difficult, illiquid 1st lien loan spreads vary from L+2.75% to L+5.00%+ More from 2nd liens and unsecured loans and bonds 15
TYPICAL PORTFOLIO LIMITATIONS 1. Concentration limitations: At least 90% 1st lien loans At most 10% second lien / unsecured loans At most 5% fixed rate assets At most 7.5% CCC-rated investments At most 60% covenant-lite loans Issuer concentration at most 2% Industry concentration at most 10% 2. Weighted Average Life at most 8-8.5 years less the time the CLO has been outstanding 3. Matrix limit for portfolio spread, diversity score, and WARF 16
SAMPLE LOAN PORTFOLIO 17
SAMPLE PORTFOLIO STATISTICS 18 Group: Total HARVST16, Total Prepay Group Graph Apr 17 Feb 17 Jan 17 Dec 16 Nov 16 Oct 16 Sep 16 Characteristics High-Yield Loans Original Balance 440 000 000 440 000 000 440 000 000 440 000 000 440 000 000 440 000 000 440 000 000 440 000 000 Current Balance 437 541 146 437 541 146 440 009 310 440 472 026 448 789 138 439 800 418 381 583 578 440 000 000 Principal Collection Account 2 507 747,41 2 507 747,41 24 898,52 159 977,76-8 207 131,63 355 631,30 58 599 423,85 0,00 Interest Collection Account 0,00 0,00 7 807 490,34 4 865 630,07 3 682 183,60 2 506 592,43 1 367 702,07 1 100 000,00 Senior Management Fee (%) 0,15 0,15 0,15 0,15 0,15 0,15 0,15 0,15 Subordinate Management Fee (%) 0,35 0,35 0,35 0,35 0,35 0,35 0,35 0,35 Incentive Management Fee Excess (%) 20,00 20,00 20,00 20,00 20,00 20,00 20,00 20,00 Incentive Management Fee IRR Threshold (%) 12,00 12,00 12,00 12,00 12,00 12,00 12,00 12,00 Gross Coupon 4,1315 4,1315 4,2719 4,3579 4,3842 4,4700 4,5587 4,7383 WAS 3,8903 3,8903 3,9886 4,0497 4,0633 4,0969 4,2106 4,2566 WAVG Rem Term 70 70 70 70 71 71 71 70 Number of Assets 176 176 181 171 171 159 142 117 Defaulted Securities ($) 0,00 0,00 0,00 0,00 0,00 0,00 0,00 - Last Equity Dividend Yield 11,8349 11,8349 0,0000 0,0000 0,0000 0,0000 0,0000 0,0000 Last Equity Dividend Yield (using implied bal) 16,1147 16,1147 0,0000 0,0000 0,0000 0,0000 0,0000 0,0000 NAV (assets at MV) 441 283 720 441 283 720 444 337 574 443 870 043 441 934 114 441 521 949 441 816 846 440 000 000 NAV Price Coverage % (assets at MV) 100,00 100,00 99,39 100,00 100,00 100,00 100,00 0,00 Market Price 100,2822 100,2822 100,9841 100,7351 100,3013 100,3106 100,4282 - Principal Collection Account before Payments ( ) 2 507 747,41 2 507 747,41 24 898,52 159 977,76-8 207 131,63 355 631,30 58 599 423,85 - Interest Collection Account before Payments ( ) 9 663 380,10 9 663 380,10 7 807 490,34 4 822 716,07 4 169 740,60 2 506 592,43 1 367 702,07 - Collateral Quality Weighted Average Rating Factor 2 587 2 587 2 591 2 584 2 570 2 571 2 554 - Weighted Average Rating Factor Limit 2 768 2 768 2 822 2 816 2 848 2 776 2 809 - Moody's Diversity Score 49 49 48 46 46 44 41 - Moody's Diversity Score Limit 40 40 40 40 36 36 36 - Weighted Average Life 5,66 5,66 5,28 5,69 5,70 5,69 5,73 - Weighted Average Life Limit 7,53 7,53 7,63 7,73 7,80 7,88 7,96 - Moody's Weighted Average Recovery Rate (%) 45,80 45,80 45,80 45,70 45,60 45,40 45,90 - Moody's Weighted Average Recovery Rate Limit (%) 43,53 43,53 43,00 42,94 43,00 43,01 42,83 - Weighted Average Coupon (%) 4,71 4,71 4,71 4,71 4,65 4,56 4,71 - Weighted Average Coupon Limit (%) 0,00 0,00 0,00 0,00 0,00 0,00 0,00 - Weighted Average Spread (%) 4,05 4,05 4,20 4,33 4,33 4,39 4,52 - Weighted Average Spread Limit (%) 3,90 3,90 4,00 4,00 4,20 4,20 4,20 - Ratings Caa1 or Less (%) 0,00 0,00 0,20 0,00 0,00 0,00 0,00 - Caa1 or Less Limit (%) 7,50 7,50 7,50 7,50 7,50 7,50 7,50 - Caa1 or Less ( ) 916 666,67 916 666,67 916 666,67 0,00 0,00 0,00 0,00 - CCC+ or Less (%) 0,00 0,00 0,00 0,00 0,00 0,00 0,00 - CCC+ or Less Limit (%) 7,50 7,50 7,50 7,50 7,50 7,50 7,50 - CCC+ or Less ( ) 0,00 0,00 0,00 0,00 0,00 0,00 0,00 - Concentrations Assets that are Cov-Lite Loans (%) 4,40 4,40 3,70 5,10 3,90 5,20 4,00 - Assets that are Cov-Lite Loans Limit (%) 30,00 30,00 30,00 30,00 30,00 30,00 30,00 - Assets that are Senior Secured (%) 99,10 99,10 99,10 99,10 99,30 99,30 99,30 - Assets that have Fixed Rate Coupons (%) 2,90 2,90 2,90 2,90 3,30 3,70 2,70 - Moody's Industry S&P Industry Moody's Ratings NR 28,69 28,69 28,24 28,04 27,23 26,72 29,94 18,58 B1 26,42 26,42 29,01 27,34 29,99 29,66 26,75 23,06 B2 26,27 26,27 25,35 25,59 25,73 25,83 21,71 11,61 Ba3 9,63 9,63 8,74 11,71 9,89 11,75 13,17 8,48 Ba2 4,25 4,25 4,27 2,70 2,65 2,00 2,83 2,81 (more) - - - - - - - - Ba1 3,49 3,49 3,48 3,48 3,41 2,91 3,36 1,25
2. KEY STRUCTURAL FEATURES Priority of payments Interest waterfall Principal waterfall Triggers in priorities of payment waterfalls Overcollateralization tests Interest coverage tests Reinvestment / interest diversion test Reinvestment criteria Collateral quality tests Weighted average life test Coverage tests 19
PRIORITY OF PAYMENTS (often 2% expected) 20
WATERFALL TRIGGERS Overcollateralization (OC) Test is roughly: Loan Portfolio Principal / Sum of note principal from AAA to test rating level Reinvestment Diversion Test is normally the same as junior-most OC Test 21
REINVESTMENT TESTS Certain tests influence manager s ability to reinvest WARF, WAS, WAC, WAL, WARR, Diversity Score These collateral quality tests need to be satisfied for reinvestment to be allowed without limitations CCC tests normally influence OC Tests rather than reinvestment If a collateral quality test fails, then the effect depends on the CLO: 22 In some, reinvested loan cannot worsen the breach of the test In some, reinvested loan needs to bring the test to pass; if impossible, then reinvestment cannot happen and AAAs are paid down instead
COLLATERAL QUALITY TESTS 23
3. CLO MANAGER Quality of the CLO manager is important Better performance for equity More liquidity and less risk for rated notes Expected defaults Manager should not be too aggressive Most important for debt Achieved returns Manager should not be playing too safe Important mainly for equity 24
CLO MANAGER (2) Skin in the game Does the manager own some of their own equity? Or do they own a vertical slice, e.g. 5% of each tranche? Normally required nowadays by risk retention rules Are equity owners aggressively pursuing high returns? Style CLO manager possibly taking undue risk Manages for equity or for debt, par build, low/high coupon, etc. Frequency of trading 25
4. COMMERCIAL POINTS CLO manager fees, normally: Senior fee 15 bps Junior fee 35 bps Performance fee: 20% of equity cash flow after 15% IRR When buying equity in primary market: Setup fees Normally investment bank charges about 1% of the notional Other setup costs are about 1-2 million Ramp-up costs Interest lost between purchasing loan portfolio and CLO issuance Normally around 1 million 26
COMMERCIAL POINTS (2) Purchase price of equity Normally around 90-95 compared to principal of equity Discount is related to how much net fees the arranger gets Additional discounts possible if buying large part of equity Purchase price of a rated note vs. coupon of the note Rated note can achieve the same return with a high price and high coupon or with a low price and low coupon Generally low price / low coupon is better for a callable floating rate note, as long as weighted average life is calculated correctly Introduces WAL risk, but the value of the sold call option is less 27
28 Pricing of CLO notes
KEY TOPICS Valuation techniques Monte Carlo simulation Expected value Cash flow model assumptions Expected default rate Expected recovery rate Expected prepayment rate Default correlations Reinvestment assumptions Recovery lag Grace period for defaults, etc. 29
VALUATION TECHNIQUES Monte Carlo simulation Run a large number (10000) simulations based on randomized defaults in the portfolio Produces a distribution of possible outcomes Expected value approach 30 Calculated expected cash flow stream based on expected default rates and other expected statistics Useful for equity But does not tell much about breadth of possible outcomes Normally under expected cash flow, rated notes never suffer losses Monte Carlo more useful for the analysis of rated notes Often also breakeven default rate computed in the expected value approach
VALUATION ASSUMPTIONS Conditional Default Rate (CDR): 2% WARF implies normally a CDR 3-3,5% Selection effect means that very few loans default in the first years Recovery rate for 1st lien loans: 65% (historical experience 60%-70%) Covenant light: 60% Senior secured bonds and floating rate notes: 55% 2nd lien loans: 20% Mezzanine: 2% Expected loss rate ~0,60-0,80% p.a. 31
VALUATION ASSUMPTIONS (2) Conditional Prepayment Rate (CPR): 20% Reinvestment into the same kind of portfolio as currently 32
PRICING OF SUBORDINATED NOTES Present value (PV) can be calculated for a given required rate of return (often 8%-12%); or Internal rate of return (IRR) can be calculated if the purchase price is known Next a few simplified calculations of subordinated note returns In reality, complex Monte Carlo or expected value calculation based on defaults, correlations, reinvestment, structural triggers, etc. Still, simple calculations are useful for sense checking results, since complex calculations are often a black box 33
PRICING OF SUBORDINATED NOTES SIMPLE RETURN: UPFRONT COSTS AMORTISED 1. Simple Sub Note Return Calculation EUR MM Interest rate Cash flow (EUR) Assets 400,00 3,80 % 15,20 Management fee 400,00-0,50 % - 2,00 Credit losses 400,00-0,60 % - 2,40 Amortisation of upfront costs - 1,09 Total net income 400,00 2,43 % 9,71 Liability costs - 359,31 1,61 % - 5,80 Net income for sub note 3,91 Sub note purchase price 48,32 Return per annum % 8,09 % Total liability structure principal 413,00 (1) Total rated debt principal 359,31 (2) Sub note notional 53,69 =(1) - (2) Sub note purchase price % 90 % Sub note purchase price EUR 48,32 Sub note equity principal 40,69 =Asset principal less liability principal Loss amortisation over 7,00 years Total loss - 7,63 =Subnote equity principal - purchase price Per year - 1,09 34
PRICING OF SUBORDINATED NOTES IRR: CREDIT LOSSES DEDUCTED FROM CASH FLOW Year BoP Principal Interest Total 0-48,32-48,32 1 5,00 5,00 2 5,00 5,00 3 5,00 5,00 4 5,00 5,00 5 5,00 5,00 6 5,00 5,00 7 40,69 5,00 45,69 EUR MM Interest rate Cash flow (EUR Assets 400,00 3,80 % 15,20 Management fee 400,00-0,50 % - 2,00 Credit losses 400,00-0,60 % - 2,40 Total net income 400,00 2,70 % 10,80 Liability costs - 359,31 1,61 % - 5,80 Net income for sub note 5,00 IRR 8,60 % Total liability structure principal 413,00 (1) Total rated debt principal 359,31 (2) Sub note notional 53,69 =(1) - (2) Sub note purchase price % 90 % Sub note purchase price EUR 48,32 Sub note equity principal 40,69 =Asset principal less liability principal 35
PRICING OF SUBORDINATED NOTES IRR: CREDIT LOSSES DEDUCTED FROM LOAN PRINCIPAL Cashflow Year BoP Assets Interest ManagemenLiabilities Liability coincome Principal Total 0 400,00-48,32-48,32 1 397,60 15,20-2,00-359,31-5,80 7,40 7,40 2 395,20 15,11-1,99-359,31-5,80 7,32 7,32 3 392,80 15,02-1,98-359,31-5,80 7,24 7,24 4 390,40 14,93-1,96-359,31-5,80 7,16 7,16 5 388,00 14,84-1,95-359,31-5,80 7,08 7,08 6 385,60 14,74-1,94-359,31-5,80 7,00 7,00 7 383,20 14,65-1,93-359,31-5,80 6,92 23,89 30,81 IRR 9,46 % Total liability structure principal 413,00 (1) Total rated debt principal 359,31 (2) Sub note notional 53,69 =(1) - (2) Sub note purchase price % 90 % Sub note purchase price EUR 48,32 Sub note equity principal 40,69 =Asset principal less liability principal 36
PRICING OF SUBORDINATED NOTES MORE DETAILS: RECOVERY LAG, RAMPUP COSTS Defaults Cashflow BoP Assets BoP Default rate Defaults Recoveries 3M LIBOR Asset WAS Interest rate Assets yielding ininterest BoP ManagemenRunning costs Liabilities Liability WAC Liability costs Other expenses Income Principal Total 1 30.6.2017 400,00 2,00 % 2,00 - -0,261 % 3,800 % 3,80 % 398,00-359,31 1,615 % 1,61 % - 48,32-48,32 2 30.9.2017 398,00 2,00 % 1,99 1,40-0,261 % 3,800 % 3,80 % 396,01 3,78-0,500-0,070-359,31 1,615 % 1,61 % - 1,45-1,00 0,76 0,76 3 31.12.2017 397,41 2,00 % 1,99 1,39-0,199 % 3,800 % 3,80 % 395,42 3,76-0,498-0,070-359,31 1,615 % 1,61 % - 1,45 1,74 1,74 4 31.3.2018 396,82 2,00 % 1,98 1,39-0,130 % 3,800 % 3,80 % 394,83 3,76-0,497-0,070-359,31 1,615 % 1,61 % - 1,45 1,74 1,74 5 30.6.2018 396,22 2,00 % 1,98 1,39-0,085 % 3,800 % 3,80 % 394,24 3,75-0,496-0,069-359,31 1,615 % 1,61 % - 1,45 1,73 1,73 6 30.9.2018 395,63 2,00 % 1,98 1,39-0,022 % 3,800 % 3,80 % 393,65 3,75-0,495-0,069-359,31 1,615 % 1,61 % - 1,45 1,73 1,73 7 31.12.2018 395,04 2,00 % 1,98 1,38 0,038 % 3,800 % 3,84 % 393,06 3,74-0,495-0,069-359,31 1,615 % 1,65 % - 1,45 1,73 1,73 8 31.3.2019 394,45 2,00 % 1,97 1,38 0,102 % 3,800 % 3,90 % 392,48 3,77-0,494-0,069-359,31 1,615 % 1,72 % - 1,48 1,72 1,72 9 30.6.2019 393,86 2,00 % 1,97 1,38 0,170 % 3,800 % 3,97 % 391,89 3,83-0,493-0,069-359,31 1,615 % 1,79 % - 1,54 1,72 1,72 10 30.9.2019 393,27 2,00 % 1,97 1,38 0,229 % 3,800 % 4,03 % 391,30 3,89-0,492-0,069-359,31 1,615 % 1,84 % - 1,60 1,72 1,72 11 31.12.2019 392,68 2,00 % 1,96 1,38 0,287 % 3,800 % 4,09 % 390,72 3,94-0,492-0,069-359,31 1,615 % 1,90 % - 1,66 1,72 1,72 12 31.3.2020 392,10 2,00 % 1,96 1,37 0,351 % 3,800 % 4,15 % 390,14 3,99-0,491-0,069-359,31 1,615 % 1,97 % - 1,71 1,72 1,72 13 30.6.2020 391,51 2,00 % 1,96 1,37 0,414 % 3,800 % 4,21 % 389,55 4,05-0,490-0,069-359,31 1,615 % 2,03 % - 1,77 1,72 1,72 14 30.9.2020 390,92 2,00 % 1,95 1,37 0,474 % 3,800 % 4,27 % 388,97 4,10-0,489-0,069-359,31 1,615 % 2,09 % - 1,82 1,72 1,72 15 31.12.2020 390,34 2,00 % 1,95 1,37 0,532 % 3,800 % 4,33 % 388,39 4,16-0,489-0,068-359,31 1,615 % 2,15 % - 1,88 1,72 1,72 16 31.3.2021 389,76 2,00 % 1,95 1,37 0,610 % 3,800 % 4,41 % 387,81 4,21-0,488-0,068-359,31 1,615 % 2,23 % - 1,93 1,72 1,72 17 30.6.2021 389,17 2,00 % 1,95 1,36 0,689 % 3,800 % 4,49 % 387,23 4,28-0,487-0,068-359,31 1,615 % 2,30 % - 2,00 1,72 1,72 18 30.9.2021 388,59 2,00 % 1,94 1,36 0,751 % 3,800 % 4,55 % 386,65 4,35-0,486-0,068-359,31 1,615 % 2,37 % - 2,07 1,72 1,72 19 31.12.2021 388,01 2,00 % 1,94 1,36 0,813 % 3,800 % 4,61 % 386,07 4,40-0,486-0,068-359,31 1,615 % 2,43 % - 2,13 1,72 1,72 20 31.3.2022 387,43 2,00 % 1,94 1,36 0,880 % 3,800 % 4,68 % 385,49 4,45-0,485-0,068-359,31 1,615 % 2,49 % - 2,18 1,72 1,72 21 30.6.2022 386,85 2,00 % 1,93 1,36 0,947 % 3,800 % 4,75 % 384,92 4,51-0,484-0,068-359,31 1,615 % 2,56 % - 2,24 1,72 1,72 22 30.9.2022 386,27 2,00 % 1,93 1,35 1,009 % 3,800 % 4,81 % 384,34 4,57-0,484-0,068-359,31 1,615 % 2,62 % - 2,30 1,72 1,72 23 31.12.2022 385,70 2,00 % 1,93 1,35 1,069 % 3,800 % 4,87 % 383,77 4,62-0,483-0,068-359,31 1,615 % 2,68 % - 2,36 1,71 1,71 24 31.3.2023 385,12 2,00 % 1,93 1,35 1,130 % 3,800 % 4,93 % 383,19 4,67-0,482-0,067-359,31 1,615 % 2,75 % - 2,41 1,71 1,71 25 30.6.2023 384,54 2,00 % 1,92 1,35 1,191 % 3,800 % 4,99 % 382,62 4,72-0,481-0,067-359,31 1,615 % 2,81 % - 2,47 1,71 1,71 26 30.9.2023 383,97 2,00 % 1,92 1,35 1,251 % 3,800 % 5,05 % 382,05 4,77-0,481-0,067-359,31 1,615 % 2,87 % - 2,52 1,71 1,71 27 31.12.2023 383,40 2,00 % 1,92 1,34 1,309 % 3,800 % 5,11 % 381,48 4,82-0,480-0,067-359,31 1,615 % 2,92 % - 2,57 1,70 1,70 28 31.3.2024 382,82 2,00 % 1,91 1,34 1,380 % 3,800 % 5,18 % 380,91 4,87-0,479-0,067-359,31 1,615 % 2,99 % - 2,63 1,70 1,70 29 30.6.2024 382,25 2,00 % 1,91 1,34 1,452 % 3,800 % 5,25 % 380,34 4,93-0,479-0,067-359,31 1,615 % 3,07 % - 2,69 1,70 22,94 24,64 2,00 % IRR 8,52 % Recovery lag 2 Recovery rate 70 % Management fees 0,50 % Running costs 0,07 % Interest income lost in rampup 37
PRICING OF RATED NOTES Pricing of rated notes is very different from equity pricing Key is to assess: 1. Probability of losses exceeding the buffer in the notes More generally expected losses in the tranche 2. Required rate of return for the CLO tranche Influenced by a large number of factors 38
RISKINESS OF RATED NOTES Amount of par subordination How much losses before the tranche gets hit Thickness of the tranche How much more losses until all principal of the tranche is lost MVOC (Market Value OverCollateralization) Tells how much credit enhancement would be left if the CLO manager sold the portfolio and purchased a new one at 100 Quality of worst assets in the loan portfolio Defaulted already or going to default soon? Ratings Market price 39
RISKINESS OF RATED NOTES (2) Structural protections OC Tests Reinvestment Diversion Test Etc. Other topics such as: Diversity score Correlation between loans Variability of recovery rates in the portfolio Variability of default rates in the portfolio E.g. over economic cycle Par erosion through buying loans above par 40
REQUIRED RATE OF RETURN Key components: 1. Expected loss in the tranche; often small, depends on assumptions 2. Volatility premium (BBs are 4x high yield in stress periods) 3. Tranche beta (CAPM; normally highly positive) 4. Illiquidity premium (liquidity is very variable) 5. Duration 6. Weighted average life risk (uncertainty of WAL / duration) 7. Complexity (work required and the chance that you got it wrong) 8. Distribution of returns (are returns capped on the upside) 9. Regulatory treatment / cost (Solvency II) 10. Regulatory and legal risk premium (strength of setup) Sometimes different for secondary and primary market 41
LIQUIDITY CONSIDERATIONS Liquidity / illiquidity for the note Investor-based for this CLO manager Strength of regulatory setup: Regulatory setup for risk retention Amount of unpriced / illiquid assets in the loan portfolio Unusual structural features Past losses in the portfolio / manager performance Other complications in the portfolio CLO market exhibits strongly variable liquidity (sometimes a lot, sometimes none) 42
DISCOUNT MARGIN CLO tranches are floating rate notes (FRN) Their coupon is LIBOR + a spread CLO notes can trade at prices ranging from less than 50 to over 100 Discount margin is the spread of an FRN trading at 100 that gives the same IRR as the note being analyzed LIBOR follows the forward curve Enables easy comparison of bonds trading at different prices and spreads 43
DISCOUNT MARGIN (2) Price 95,00 100,00 Spread 3,5000 % 4,3822 % Year LIBOR Note Par bond 0 0,50 % - 95,00-100,00 1 0,75 % 4,00 4,88 2 1,00 % 4,25 5,13 3 1,25 % 4,50 5,38 4 1,50 % 4,75 5,63 5 1,75 % 5,00 5,88 6 2,00 % 5,25 6,13 7 105,50 106,38 IRR 5,5781 % 5,5781 % 44
MARKET LEVELS FOR CLO NOTE DMS 45 27.11.2017: US Euro B 700 690 BB 500 490 BBB 250 245 A 170 165 AA 140 120 AAA 112 75 11.5.2017: US Euro B 850 800 BB 675 580 BBB 375 320 A 275 210 AA 200 150 AAA 120 90