Leveraged Finance Ch 4: Collateralized Loan Obligations

Question 1

What assets do collateralized loan obligations hold?

Answer 1

A collateralized loan obligation is a structured financial product that is backed by a
portfolio of leveraged loans

These are loans that banks made to corporations with speculative-grade ratings

The pool of loans is usually managed by an asset manager

Question 2

Describe the capital structure/liabilities of a CLO

Answer 2

Cashflows from the underlying pool of a CLO are distributed to debt and equity (i.e.
tranches) issued by the CLO
In order of payment seniority in the CLO’s capital structure, these tranches are:
1. Senior debt
2. Mezzanine debt
3. Subordinated debt
4. Equity

Question 3

Describe two different motivations for the creation of a CLO

Answer 3

1. Balance sheet
   Ÿ For a balance sheet CLO, banks sell loans to the CLO in order to reduce the size of
   its balance sheet and reduce its regulatory and economic capital
2. Arbitrage
   Ÿ The asset manager specializing in the pool of loans seeks to increase assets under
   management and management fees
   Ÿ The asset manager assembles the initial portfolio of an arbitrage CLO

Question 4

What is the par coverage test of a CLO tranche?

Answer 4

CLO’s have cash-flow waterfalls that specify par coverage tests that allow the diversion
of cashflow to the most senior tranche if the coverages tests for the tranches are not
satisfied

For example, the par coverage tests for Class A and Class B of a CLO requires:
Class A Par Coverage Test
Total Par of CLO Loan Pool
Class A Par ¡ 1
Class B Par Coverage Test
Total Par of CLO Loan Pool
Class A Par 􀀀 Class B Par ¡ 1

Question 5

Describe four main reasons why investors should purchase CLO equity

Answer 5

1. The nonrecourse term financing that CLOs provide to CLO equity
2. The cash flow CLO structure is very forgiving to CLO equityholders; provides
   significant return even when CLO debt holders are destined to receive less than
   their due
3. CLO equity holders have the following two call options that further increase their
   investment value
   3.1 Call option on the market value of assets in the CLO portfolio, which is exercised by
   liquidating and unwinding the CLO
   3.2 Call option on the postdefault cash flow of the CLO asset portfolio
4. CLO equity can be viewed as a defensive investment strategy

Question 6

Describe the nonrecourse term financing of CLOs in more detail, and how that impacts
CLO equity holders

Answer 6

CLO equity holders own stock in a company and are not liable for the losses of
that company

A cash flow CLO cannot be forced to liquidate its assets

Debt tranche holders only have recourse to the CLO’s assets, and cannot make
any additional claims against equity holders

CLO equity holders are not at risk for anything beyond their initial investment

Question 7

List the key factors of CLO equity returns

Answer 7

1. The promised yield of the CLO’s underlying asset collateral (in the absence of
   defaults)
   Ÿ The CLO equity investor only needs to look at the underlying portfolio’s weighted
   average coupon to determine what the expected yield would be
2. The CLO’s funding cost
   Ÿ This refers to the coupon payments the CLO must make to the different debt
   tranches (senior, mezzanine, etc)
3. Amount of leverage in the CLO structure
4. Cash-flow structure of the CLO (includes the par coverage tests)
5. Collateral’s default and recovery performance

Question 8

Which factor of a CLO’s equity returns is historical data most useful for modeling the
expected future returns of the CLO equity tranche?

Answer 8

The default and recovery rates of the underlying CLO asset portfolio