The other mechanism that protects debt investors in a CLO (besides the cashflow waterfall) is a series of tests relating to the quality and performance of the CLO.
The collateral administrator checks the CLO’s compliance with these tests each month. If a test fails, the rules of the CLO change in some way – usually to the benefit of debt investors and at the expense of equity investors.
The most important test for most CLOs is the overcollateralisation test. If it fails, the CLO manager generally has to stop making new investments and must use all available income to pay down the CLO notes.
Overcollateralisation tests compare the par value of the CLO portfolio (adjusted for defaults and imminent defaults) with the par value of the CLO notes. This ratio must be above a predetermined threshold for the CLO to pass the test each month.