Guide to CLOs

7. Debt tranches
and ratings

Typically, CLOs are around nine times levered, and therefore a large majority of all CLO liabilities are debt tranches.
Types of CLO debt
A wide array of CLO debt securities exist, ranging from those with very low risk and returns to those with high coupons and higher risk of non-payment. Different CLO notes also have different legal forms and carry different structural features. There are also a wide range of CLO debt investors using various investment strategies. Some look to hold an investment for its entire life. Others, such as hedge funds, look to trade CLO debt by buying at a discount and selling it later at a higher price.
Ratings: opinions that matter
One thing that distinguishes most CLO notes from CLO equity is that they are almost always rated. A rating is an opinion about the risk of a bond using a standardised scale made by a rating agency, a company that specialises in such opinions. Many CLO investors need or value ratings as a way of showing to their clients, beneficiaries or regulators that they are choosing investments with an appropriate level of risk.
When rating corporate bonds or loans, rating agencies look at measures such as the company’s level of indebtedness, its cashflows, its access to finance and the dynamics affecting its industry. They then apply some level of judgment to come up with an appropriate rating. In principle, rating a CLO should be more straightforward than rating a corporate bond. Assuming that the rating agency already rates all the underlying assets, it simply needs to figure out how the risk of the portfolio is shared between the different tranches.

A different animal

CLO equity, which is discussed in the next chapter, makes up less than 20% of total CLO liabilities.
CLO equity is a very different kind of investment from CLO debt since it has both higher risk and greater upside.
However, reality is not so simple. For one thing, the rating agency may not rate all the corporate borrowers in the portfolio. For another, the differences in the waterfalls and other rules from one deal to another make it difficult to rate CLOs using a simple, formulaic approach.
And, more fundamentally, nobody knows (until it happens) how defaults in a portfolio feed through to losses for different CLO tranches. Most CLOs throughout the history of the market have survived without inflicting any losses on debt investors. So CLO default is an event with low probability. That makes it hard to predict, and highly dependent on the assumptions used.
Each of the rating agencies involved in rating CLOs has a different methodology for coming up with its ratings. The main rating agencies involved are Fitch Ratings, Moody’s Investors Service and S&P Global Ratings. Other rating agencies such as Kroll and DBRS Morningstar are involved to a lesser extent, mainly by giving private ratings for CLOs in specific circumstances.
The methodologies used by the rating agencies to rate CLOs have evolved over time. All publish details of their methodology, but not in such detail that an outsider could be certain of guessing what their rating on a particular tranche would be. This is deliberate. Rating agencies fear that if they make their rating methodology public as a series of mathematical rules, then the investment banks that structure CLOs will find ways to “arb the ratings”, that is, include assets or features which boost the CLO’s ratings while adding to its real risk.
Especially following their experience of mis-rating structured products such as subprime mortgage-backed securities in the lead-up to the financial crisis of 2007 and 2008, rating agencies like to retain an element of discretion in rating CLOs.
In many respects, Fitch Ratings and S&P Global Ratings take a similar approach to ratings, while Moody’s is a little different from the other two. This is true, for example, of what the agencies say a rating actually means. For Fitch and S&P, the rating of any debt is their opinion of its likelihood of suffering any kind of loss. This is referred to as a first-dollar-of-loss approach. Moody’s, by contrast rates to what it terms an expected loss. This is an opinion of the magnitude of loss that any debt can be expected to sustain during its life. The difference sounds small. But it could be important for a bond that has a high likelihood of suffering a default but a very high expected recovery rate in the event of such a default. The Moody’s rating for such a bond should be higher than the S&P or Fitch rating, assuming that they are all in agreement about the bond’s default and recovery risk.

Similarly, Moody’s takes a rather different approach to rating CLOs than the other two agencies. Moody’s general approach is first to take the proposed CLO portfolio and convert it into a series of numerical scores. One is a rating factor (weighted average ratings factor or warf) based on ratings of the underlying assets, which represents the average default risk of the portfolio (ranging from 1 for Aaa risk to 10,000 for anything below Caa3). Moody’s also comes up with a single number to address correlation within the portfolio, the diversity score.
Moody’s then puts this version of the portfolio through a model which takes account of the cashflow rules of the CLO. The model gives an expected loss calculation for each tranche under a number of different scenarios. Moody’s then compares this expected loss with a target expected loss rate which it believes is appropriate for each rating over the covenanted life of the deal. For example, a CLO tranche needs to have an expected loss over its life of below 0.0055% in order to gain a rating of Aaa. The agency also imposes additional haircuts, or stress factors, to take account of any other risks it identifies in the deal.
Both Fitch and S&P use a Monte Carlo modelling approach to rating CLOs. This is a model that uses heavy computing power to calculate the result of many different scenarios for the portfolio at each rating level, such as different levels and patterns of default, different interest rate projections and different timings of defaults.
From this, the agencies calculate how many defaults it would take for each tranche to suffer a loss. They compare this to what S&P and Fitch call a break-even default rate for each tranche. These are a number of defaults compatible with a desired rating that a given tranche should be able to sustain. In other words, a tranche rated AAA would need to be able to withstand a much greater number of defaults than one rated BB, for example.
A typical ratings history: Moody’s ratings on California Street V
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A question of correlation

One of the trickiest parts of assessing the loss probability of a CLO note is figuring out the correlation between the default risk of each of the borrowers in the portfolio. This may sound abstract but it is an important concept.
Imagine a CLO in which each loan in the portfolio has a 5% chance of defaulting during the life of the deal. If each of those default probabilities is independent of any other default probability, then the portfolio will likely sustain 5% losses (before recoveries) during the CLO’s lifetime.
That would be enough to hurt equity investors, who typically make up the bottom 5% of the CLO capital structure, but not enough to cause losses to the CLO debt.
But if the default probability of the different loans is not independent, then losses on the portfolio could be much higher (or lower) than 5%. For example, if the portfolio contains many borrowers from the car industry, then under some scenarios (consumers moving away from traditional car ownership) losses could be catastrophic, and might be enough to wipe out several tiers of CLO debt investors.
For this reason, rating agencies place great importance on ensuring that the CLO portfolio is sufficiently diverse to be able to withstand heavy losses in any particular industry.
Moody’s does this through a diversity score, a measure based on the industry classification of the borrowers in the CLO. Fitch Ratings and S&P Global Ratings factor correlation into their models and require CLOs to limit their concentration to any particular industry.
Fees for ratings
Rating CLOs takes plenty of work on the part of rating agencies, and the agencies need analysts with specialist knowledge to keep a close eye on CLOs and their ratings once the deal is complete (this is known as ratings surveillance).
For their efforts, rating agencies generally take an upfront fee in the order of seven basis points (0.07%) of the size of all the tranches they rate. In pre-crisis CLOs it was common for all tranches above the equity to carry two or more ratings. Since the crisis, it has become rare to see a tranche with three ratings, and many carry only one. Even so, a $500 million CLO with dual ratings on at least some of its debt can easily pay $500,000 to rating agencies in upfront fees.
Rating agency fees are higher when there are shadow ratings (see box below).

A quick guide to ratings symbols

The tabel opposite shows the ratings levels of the three main rating agencies. Note that S&P and Fitch have various ratings for assets that are in default, since their ratings relate to probability of default. Moody’s does not have an “in default” rating, since its rating instead addresses expected loss.
In this guide we use the specific agency’s preferred symbol when we are talking about that particular agency’s rating, and we use phrases such as “triple A”, “double A” and so on to refer generically to ratings of that level from any rating agency.
One consequence of the financial crisis is that rating agencies are now required to add a suffix such as SF to any of their ratings that refer to an asset-backed security, including a CLO. In practice, market participants (other than rating agency officials themselves) tend to omit these when discussing CLO ratings.
Progress reports
Part of the reason that many investors like their CLO investments to be rated is the knowledge that someone is keeping an eye on the performance of the CLO and the quality of its portfolio. This is especially important for an investor that owns many investments and does not have the resources to monitor each one in detail.
Of course, many investors do want to keep a close eye on how their CLOs are performing. CLOs differ from investments such as hedge funds in that they provide very detailed reports to all their investors. Generally, all classes of investors, including debt and equity, receive the same regular reports. They are popularly known as “trustee reports” but in reality are prepared by the portfolio administrator (which is often the same company as the trustee). In addition to these number-based reports required under the rules of the CLO, the manager may choose to send out its own more descriptive commentary on the performance of the CLO and the state of the market.
Pinch to zoom in
There are two main types of report. The most frequent is a monthly report which lists the CLO’s current assets, gives the size and price of all purchases and sales in the month, details its cash balances and reports whether it is in compliance with the various performance tests (see chapter 6: Understanding the tests).
Investors receive an additional report at each payment date (either quarterly or every six months depending on the payment frequency of the CLO). This is known as the note valuation report, and it shows how much cash the CLO has received in that period and details all the payments the CLO has made. This report shows how the CLO’s interest waterfall and principal waterfall are working in practice (see chapter 5: Understanding the cashflows), including how much money is left over to pay equity investors after all the other classes of investors have received their payments.
Note that one obvious piece of information is often absent from both of these reports. These reports ignore the market value of the loans that the CLOs own (except where they are in default or have been downgraded into the triple C bracket). But investors will generally make their own efforts to find out the market value of the portfolio since this information is extremely important to most of them, and a growing number of managers are choosing to include market value data.
In addition to monthly reports and note valuation reports, investors receive occasional notices, to tell investors, for example, that a CLO’s rating has changed. If the CLO manager wants to make a minor change or correction to the terms of a CLO – a change that does not require the approval of investors – the trustee will send a notice to investors about the change. If the manager wants to make a more significant change (see chapter 3: How does it happen?) then the trustee will send a notice to investors explaining the proposed change and inviting them to vote on the matter.

Ratings in the shadows

As we have seen, the ratings on CLO tranches are derived from the ratings on the CLO’s individual assets.
So if a rating agency is asked to rate a CLO which owns (or will own) loans on which the agency does not have a current rating, the rating agency faces a problem.
This situation is common for European CLOs and US mid-market CLOs. In Europe, many widely owned and traded loans are not rated or carry only one rating. In the US mid-market, very few borrowers or loans are rated by any agency.
One solution is for the rater to use another agency’s rating for the loan in question. In some cases, rating agencies will take another firm’s rating as the starting point and apply a reduction to that rating (a process known as notching) to account for the fact that it cannot itself vouch for the quality of the rating.
But for the many assets that have no rating at all, this is not possible. In this case, the rating agency will often create a private rating on the loan, sometimes known as a credit estimate, or, more commonly, a shadow rating.
This shadow rating differs from a conventional credit rating on a company and its debt in several respects:
The rating agency does not make the shadow rating known publicly.
  • The shadow rating is not paid for by the loan borrower. Instead, it is paid for by the CLO on an annual basis.
  • The fee for providing the shadow rating is less than the amount a rating agency would charge a company for a full rating.
  • A shadow rating is based on more limited information than for a full rating, and that information is provided by the CLO manager, not by the company directly.
  • The rating agency carries out much less surveillance of the borrower than in a conventional rating.
Different kinds of CLO debt
CLO debt can take several different legal forms. Almost all CLO debt is documented in the form of bonds, although there have been some cases of CLO liabilities issued in the form of loans. These legal formats depend directly or indirectly on investor preferences.
CLO notes are generally issued in a form that allows investors to switch between two different types of note known as 144A and Regulation S (Reg S).
Broadly, US investors buy 144A notes and non-US investors buy Reg S notes. A 144A is a private placement, meaning that the issuer is exempt from the onerous marketing stipulations of US securities laws. Reg S bonds are bonds issued to international investors (and therefore also exempt from the same laws).
In practical terms, what this means is that 144A bonds are cleared through the US DTCC and carry a cusip identifier number. Reg S bonds, meanwhile, clear through either Clearstream or Euroclear and are identified with an isin identifier number.
One may imagine that having different formats would impede trading of CLOs in the secondary market. But this is not the case. If a holder of a 144A CLO note wants to sell to an investor who requires a Reg S note, or vice versa, the format of the note is simply changed by a clearing house.
The legal format of a CLO investment makes no difference to the payment that investors receive. However, there are several kinds of CLO debt that have unconventional payment profiles.

Getting to know the investors

One thing that some people find surprising about the CLO market is that none of the participants actively involved in a CLO necessarily know who the deal’s investors are.
The arranger will know which institutions initially bought the CLO’s liabilities but at least some of these securities will change hands during the life of the deal.
The trustee may well be in touch with a CLO’s investors, since they will usually sign up to receive information sent out by the trustee. But it is not the trustee’s job to maintain a definitive list of investors.
The payment agent, who is usually also the trustee, is the party that arranges all payments by the CLO, including to its investors. But in most cases it does not transfer the money directly to investors. Instead, the money is received by a securities depository, such as DTCC. This is an organisation that specialises in keeping a record of the ownership of bonds and other securities and ensuring that payments go to the right holders.
The manager may know many of its CLO investors, but in most cases will not know who all of them are. This can make it hard to secure agreement to changes to a CLO’s rules, a change of manager or a decision to call the CLO. For this reason, the manager will often ask the trustee to send a notice to investors encouraging them to make themselves known to the manager.
Fixed or floating
Perhaps most commonly, a minority of CLO notes carry a fixed rate of interest. This is in contrast with the majority of floating rate CLOs, where the interest rate moves up and down at some margin above a reference rate.
The main reason that most CLOs have floating interest rates is that the loans which make up most or all of every CLO portfolio are themselves floating rate instruments. If a CLO’s capital structure consisted mainly of fixed rate notes, there would be a risk that the CLO could become unable to make payments purely as a result of changes in prevailing interest rates.
However, some CLO investors have a preference for fixed rate notes, and it is not uncommon for a CLO to issue some portion of a tranche in fixed rate format.
Triple A oddities
One unusual kind of CLO note is a junior triple A tranche. In most CLOs, triple A rated tranches represent the most senior form of debt in the capital structure. However, some CLOs are structured in such a way that the second most senior tranche also benefits from a triple A rating.
Junior triple As are not created because of any particular demand for this kind of note. The reason they exist is to keep the main triple A investors happy. By removing a slice from the bottom of the triple A portion of the capital structure, the senior investors end up with a smaller triple A tranche. This benefits from greater subordination (the amount of liabilities more junior than a given tranche) than would be the case if the junior triple A tranche had not been removed. It appeals to some investors who want a note that is not only triple A but is triple A with a decent amount of cushion.
This then leaves the arranger with the problem of what to do with the slice it has removed from the bottom of the senior tranche. The answer is usually to sell it to the kind of investors who normally buy double A-rated notes.
Another triple A note which differs from most other triple As is known as a class X tranche. The letter X has been used in different ways during the history of the CLO market to indicate a tranche which does not form a conventional part of the capital structure. In post-crisis CLOs, X has sometimes been used for a very short-dated tranche which sits at the top of the capital structure.
This note is typically issued to provide the CLO with a small cushion of extra cash during its first few weeks, when the deal faces unusually high expenses for one-off items such as fees.
Stepping up
While most CLO notes have coupons that remain unchanged throughout their life, a few CLO tranches include a coupon step-up feature. This simply means that at some point in the CLO’s life the coupon increases to a new pre-defined level. At this point, equity investors invariably have the right to call the CLO. The step-up is included at the request of debt investors who believe it makes it more likely that the CLO will be called at the step-up date, giving them greater certainty over the expected life of their investment.
Combining cashflows
Combination notes have been rare since the financial crisis, but were relatively common in the CLO market around 2005 and 2006. A combination note, or combo, is a bond that consists of two different notes. Most commonly, it combines a CLO equity tranche with a senior tranche, usually the triple A. An investor in the combination note receives cashflows from the two constituent bonds in whatever ratio they are included in the note. So, holders of a $5 million combination note that combines 80% of triple A notes and 20% equity, would receive the same payments as if they held $4 million of triple As and $1 million of equity.
Combination notes can be defined in the CLO waterfall or they can be put together by an investment bank quite separately from the CLO in a repackaging of two existing bonds.
The purpose of a combination note is to create an investment that has a high probability of full (or near full) return of principal with a better yield than is usually available on a very safe tranche. This appeals to certain kinds of investors, such as some insurance companies, that require their investments to be highly rated but also want greater yield.
Of course, there is no such thing as a high yielding, completely safe investment. Combination notes are typically rated only for their ability to return principal. Investors’ coupons are at much greater risk than in a comparably rated CLO that is not a combination note.
Old wine: new bottles
CLO debt tranches are occasionally transformed into a new form for particular investors in a process known as repackaging. An example which appeared in 2017 was the repackaging of some triple A notes into Japanese yen. In this case, the arranger creates an entity which buys some of the original dollar-denominated notes and then issues notes in yen (also entering into a currency swap with an investment bank – typically the arranger).