In this case, the total amount of principal that can be distributed across the tranches is equal to those received on the loans. In our stylized example, the only credit enhancement for the CLO’s notes is through overcollateralization (OC) based on the par amount of the underlying loans. Thus, to a certain extent, our simplified CLO is a ‘worst case scenario’ for the notes. Relaxing these assumptions, which may be considered for possible future research, is relevant since excess interest is typically available to a CLO where the cash flow priority rules serve first to reduce the amount of portfolio credit loss that is allocated to the notes and secondly reorder the allocation of the remaining losses. These assumptions will ensure that the total credit loss of the portfolio will equal the aggregate credit losses allocated to the CLO’s tranches. This assumption is an important building block to gain a good understanding of how losses are measured and allocated to the CLO’s tranches. We assume no interest on the collateral, nor on the CLO’s tranches. For simplicity, we ignore interest payments and discounted cashflows. To begin, we assume a static portfolio of loans that is well diversified, with certain homogeneous characteristics (e.g., credit quality, maturity, seniority) and has a total par amount equal to the amount of CLO notes issued.įurthermore, we assume the CLO has a simple capital structure with three classes of notes (Class A, B, and equity) paid in order of straight sequential seniority. In order to illustrate both the complexities of estimating portfolio credit losses and how the estimated loss distribution of an underlying pool of leveraged loans may be allocated across a CLO’s capital structure, we have created a simple example. Excess interest and other structural deal features could materially reduce the estimated portfolio credit loss and the allocation of such losses across the CLO’s notes – translation: the answers to the questions above could vary substantially once excess interest and structural deal features are considered.Ī Simple Example to Demonstrate CLO Complexities.Estimating portfolio credit losses is as much an art as a science and is subject to significant judgment.The first loss equity tranche absorbs most of the estimated portfolio credit losses.To explore this complex issue and to come to an understanding of the outcome of credit loss, we ask two fundamental questions:įirstly, how is the total portfolio credit loss allocated across the CLO’s notes? And, secondly, what is the total loss of the underlying portfolio that is to be allocated to the CLO’s notes? Obviously where that risk comes to bare and CLO credit losses are incurred, there are challenges to estimate and allocating that loss. This therefore offers investors the opportunity to participate in this asset class based on their own risk and cash flow preferences.Īn assessment of how the underlying risk is distributed across the notes is fundamental for investors and other market participants. As structured finance market participants are aware, notes issued by collateralized loan obligations (CLOs) introduce varying credit exposures to the underlying corporate leverage loan portfolio based on the relevant notes’ cashflow priority.
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