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commercial mortgage-backed securities (CMBS) and other CLOs). Post-crisis, around 2010, a new
vintage of CLOs emerged with structural changes that were intended to strengthen credit support,
including a shortened reinvestment period (whereby the principal and interest proceeds from the
underlying bank loan portfolio would be reinvested into additional loans). Then around 2014, the
current vintage of CLOs began, which eliminated the “bucket” of high-yield corporate bonds that was
previously allowed in the portfolio.
For diversification purposes, CLOs are structured with specific investment limitations, such as issuer and
industry concentrations, which aim to protect investors from potential losses. For example, a CLO’s
underlying portfolio may consist of 100 or more issuers across several industries. There are also limits to
the total amount of CCC-rated investments that may be included in the underlying portfolio, which are
typically limited to 5%–7.5% of the total portfolio.
What Are the Dynamics of a CLO Structure?
CLOs are generally structured as cash flow (arbitrage) transactions, whereby income generated by the
underlying collateral (i.e., principal and interest on the bank loans) is used to pay debt service to the
noteholders and equity investors. In the early stages of structuring a CLO, bank loans are purchased by
the CLO manager and warehoused (usually for a period of three to six months) prior to the transaction’s
closing date. Upon closing, the transaction then has a ramp-up period during which time the CLO
manager purchases additional collateral to complete the portfolio. Thereafter, there is a reinvestment
period, which lasts anywhere from two to five years, whereby trading of the bank loans may occur. That
is, during this time, the asset manager may purchase or sell bank loans to improve the portfolio’s credit
quality. Sales activity is classified as either discretionary, credit risk (when an impaired asset is sold) or
credit improved (when an asset is sold at a premium). After the reinvestment period has ended, the CLO
manager uses proceeds from interest income on the bank loans, bank loan repayments and maturities
to pay down the CLO debt in order of priority/seniority (known as the amortization period), and
distributes any remaining proceeds to the equity investors as their return.
A CLO is also structured with a “non-call” period in the first two years of its life immediately following
the closing date. After this period, the majority equity investor can call the deal (redeem it in full) if the
transaction achieves a particular yield spread, and the CLO debt holders can be paid back in full.
Cash-flow distributions on payment dates (also known as the “waterfall”) begin with payments to the
senior-most CLO tranche, which receives the highest claim on the flow of funds, followed by payment to
the lower-rated tranches, in order of seniority. (See Chart 2.) In addition, on payment dates, the
structure must achieve performance-based tests, such as the aforementioned minimum O/C level for
each tranche layer, before funds flow through to make payment on the additional tranches. To “pass”
the O/C test, the principal value of the underlying collateral must exceed the principal value of the CLO
tranche by a predetermined minimum ratio. Failure to meet the minimum O/C level at any point in the
capital structure results in redirecting the flow of funds to achieve this level, taking away from making
payment to lower-rated tranches. Any funds that remain at the end of the waterfall may be distributed
to equity investors as a return on their investment.