Properties of Duration
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Collateralized Debt Obligations (CDOs) are financial instruments issuing securities backed by diversified debt pools. These diversified pools can include corporate bonds, emerging market bonds, leveraged bank loans, and even other CDOs. Among them, the most common are Collateralized Loan Obligations (CLOs), backed primarily by leveraged bank loans.
CDO structures reallocate the cash flows generated by the underlying collateral to various tranches. However, unlike ABS, CDO pools are not static. A collateral manager who actively manages buying and selling debt obligations must ensure cash flows are sufficient for the CDO bondholders. A pivotal consideration for these transactions is the collateral pool’s return rate compared to the funding costs. Since CDOs leverage transactions, equity tranche holders use borrowed funds to achieve a return surpassing the funding cost.
The CDO market mainly focuses on CLOs backed by senior secured bank loans. They offer a diversified portfolio of company loans.
CLOs source funds for collateral assets by issuing various debt obligations, categorized into senior, mezzanine, and subordinated/junior/equity tranches. Investors in senior or mezzanine tranches may receive higher yields than corporate bonds or access debt products usually out of their reach. Meanwhile, equity tranche investors face risks similar to equity, with potential returns to match.
Cash Flow CLOs redistribute interest and principal payments, while market value CLOs depend on portfolio market value. On the other hand, synthetic CLOs use credit derivatives to create their collateral pool.
A distinctive aspect of CLOs is that their portfolio might not be finalized immediately after transaction closure. There is often a ramp-up period when more assets join the collateral pool. Once set, the manager can still swap out loans if replacements meet portfolio criteria. The CLO life cycle concludes when underlying loans mature and tranches receive payments in the defined order.
CLOs employ various tests to ensure the bank loan collateral’s cash flows meet the obligations of the various tranches. Overcollateralization tests are prevalent, ensuring the CLO’s underlying bank loan pool’s principal value does not surpass the issued notes’ principal value. For instance, if a CLO promises USD600 million of principal across its tranches, it might need to procure USD780 million of bank loans, leading to an overcollateralization ratio of 1.30.
Additionally, each tranche in a CLO has its overcollateralization ratio targets. If the ratio dips below the set limit, cash flows divert to purchase more collateral or repay the most senior debt tranche. There are also other tests considering the diversity of borrowers, industry diversification, and even the credit ratings of the loans within the collateral pool.
Collateral managers are integral to the performance of CLOs, actively determining the asset mix, managing risks, and ensuring ongoing performance tests and collateral limits are adhered to. If these standards are not met, provisions mandate redirecting the principal payoff to the senior bond class.
Question
Which of the following best describes the role of an overcollateralization test in a CLO?
- It ensures that the interest rates on the bank loans exceed the CLO’s funding costs.
- It confirms that the total principal value of the issued notes should be less than the principal value of the bank loan pool.
- It ensures that the CLO’s underlying bank loan pool’s principal value does not exceed the issued notes’ total principal value.
Solution
The correct answer is C: The overcollateralization test ensures that the principal value of the CLO’s underlying bank loan pool does not exceed the total principal value of the notes issued by the various CLO debt tranches.
A is incorrect: This relates to the basic economics of CDO transactions, not the overcollateralization test.
B is incorrect: This represents the opposite of what the test ensures.