9. How are CLOs priced?

How are CLOs priced? It’s simple. The price of a CLO depends on what someone is prepared to pay for it. As in any other market, the balance between supply and demand determines the price.

Doing this with a corporate bond is hard enough, since the investor needs to make assumptions about how likely the bond is to default and its recovery rate if default happens. To do this with a CLO debt security is harder still. The level of the note’s coupons may be predictable, but the probability of receiving those interest payments and the size of the final principal payment (if any) depend on the level and the timing of defaults in the portfolio.

The timing of the final cashflow is particularly hard to estimate. The weighted average life of a CLO note is determined by the speed at which the CLO pays down its debt, by the number and timing of defaults and by when the CLO equity investors choose to exercise their call option.

A widely used approach to CLO analysis is to “run the cashflows”. This is an exercise in which the would-be investor looks at the rules governing the CLO’s payments, such as the order of the waterfalls and the trigger levels of the overcollateralisation and interest coverage tests, and then projects all the payments that the CLO will make to each of its tranches. This forecast requires the investor to make various assumptions about what happens to the CLO portfolio (see Tweaking the variables, below).

In the early days of the CLO market, investors made these forecasts using spreadsheets they created. Such spreadsheets were cumbersome to manage and prone to errors. However, there are now many software tools which allow investors to run forecasts, such as those from Intex or Moody’s Analytics.

However the calculation is done, the cashflow forecast will depend on the rules of the CLO having been interpreted correctly. The forecast will also vary greatly according to which assumptions the analyst uses when running the model.

Share buyers know that a company’s share price means nothing in isolation. To compare it with the shares of any other company, the investor needs to look at how the share price relates to the company’s earnings and balance sheet.

Similarly, CLO prices mean little in isolation. In order to make comparisons between CLOs, investors need to convert prices into yield terms. Because CLOs are usually floating rate instruments, the standard measure of spread is a discount margin.

Converting prices into discount margins and vice versa is relatively simple bond mathematics (see Making the numbers work on the previous pages) provided the investor knows the weighted average life of the bond. But, as mentioned before, this requires cashflow forecasting.

One class of loans, known as the revolver and A tranche, do commonly receive some principal back well ahead of their maturity date. These loans, sometimes known as the pro-rata tranches, are usually bought by banks rather than CLOs and other institutional investors. CLOs typically own only a small amount of these loans (usually less than 5% of their portfolios). They therefore often receive only a small amount of loan repayments during the life of the CLO from these kinds of assets. However, most of the loans owned by CLOs are the B and C loans, which have a longer maturity profile (but the same seniority) as the pro-rata tranches. These “institutional” classes of loan do not usually amortise until close to their legal maturity. Typically, the company that issues the loan will either choose to pay it back well before maturity or will default.

The CLO analyst needs to make an assumption about the amount of loans in the portfolio that will be refinanced every year – in other words, the speed of prepayments. The rate of prepayments partly reflects the prevailing borrowing rate for high yield corporate borrowers. When they can borrow cheaply, companies will tend to prepay faster. If many companies are facing difficulties or if borrowing costs are high, they are less likely to repay their loans.

The CLO analyst could forecast prepayment levels by simply projecting today’s rate of repayments forward. Alternatively, he or she could look at average historical repayment rates. Often, as with defaults, analysts use a flat prepayment rate for the life of the deal.

A typical approach is to assume that future proceeds will be invested at some level of spreads similar to those prevailing today.

Many CLOs, especially older deals, allow the manager some leeway to make investments after the end of the reinvestment period. So, the analyst needs to make an assumption about what proportion of repayments the manager is able to deploy into new assets post-reinvestment.

A common simplistic assumption is that the manager will be able to re-invest all the prepayment proceeds while the CLO is within its reinvestment period and 50% of them after the reinvestment end date.

Modelling CLOs using flat, across-the-board assumptions has the benefits of speed and simplicity. But many investors prefer to use what they regard as more realistic projections of defaults, recovery rates, prepayment rates and so on. Using their own assumptions may give them insights into whether a particular CLO bond is underpriced or overpriced compared to other assets.

Many investors run cashflows using something other than a flat projection of defaults. A popular approach is to assume that there will be a spike in defaults at some point in the life of the deal. This comes a little closer to the real world, where defaults tend to remain low for long periods of time and then jump higher during recessions.

Similarly, investors may choose to model the cashflows using the assumption that prepayment rates and prevailing loan spreads will fall and rise depending on where we are in the economic cycle.

Two other areas of modelling require a different kind of analysis.

Standard CLO modelling assumes that the CLO will remain outstanding until it receives and deploys enough principal to pay down all its notes. In practice this is unlikely to happen. Instead, equity investors will choose to call the deal well before the most junior notes start to amortise.

It is difficult to forecast the date of a CLO call, but it can have an even greater impact on the CLO note’s weighted average life than any other factor.

CLO equity investors do not always act rationally. CLOs commonly remain outstanding beyond the point at which they could be refinanced more cheaply. The most common reason for this is that the equity is held by a large number of different investors and it proves impossible to muster enough votes to trigger a call.

Therefore, CLO analysts need to gain an understanding of who the equity investors are in order to forecast the timing of a call. This information is not usually available in any public source. But investors may be able to glean some information on who the holders are from contacts who were involved in selling the deal in the first place, or who have traded the bonds in the secondary market.

Pricing in the two markets is closely connected. But there are differences. Partly, they reflect the fact that the CLOs being issued today aren’t identical to the deals that change hands in the secondary market (see chapter 10: How the secondary market works). Partly, the variations result from the different dynamics of the two markets, and the different ways that investors use these markets.

In the primary market, CLOs may price at par or at a discount, depending mainly on the preference of investors. Often pricing at a discount is a way for debt investors to reduce the risk of the CLO being called early.

For example, if the market price of a new CLO note is 600 basis points over the risk-free rate, the arranger and investors may choose to have the bond pay a 550 basis point coupon but price at less than par. This amounts to the same thing. But it reduces the incentive for the equity investors to call the CLO. It only becomes economical for them to call it once spreads fall to 550 basis points rather than when they are at 600 basis points.

So, whereas CLO debt is usually priced in terms of its spread over a low-risk investment such as US dollar Libor or Euribor, this approach does not work for equity. Rather, CLO equity investors try to estimate the absolute return they will receive over the life of their investment, just as investors in a hedge fund or private equity fund would.

Future returns are converted into today’s money using a discount rate which is itself the investment’s expected return. In other words, the investor conventionally assumes that any money received is reinvested in an instrument that provides an identical return. This calculation is called an internal rate of return or IRR.

Besides calculating the expected IRR of the investment, CLO equity investors have a second way to think about valuation. The value of the equity tranche should be the total market value of all the CLO’s assets minus the total market value of its debt (that is, all the tranches above equity in the capital structure). This is referred to as the net asset value of the CLO or sometimes as the market value overcollateralisation.

There are various practical problems in calculating a CLO’s net asset value. For one thing, there may be no visible market price for the CLO’s debt. On the other side of the balance sheet, the investor may well feel confident about the value of most of the CLO’s assets. But there are usually at least a handful of assets in each CLO that are illiquid or obscure and for which it is hard to estimate a price.

One of the biggest uncertainties for CLO equity investors is that they do not know what future assets the manager will buy. When they are marketing the deal to prospective investors, the manager and arranger will often show a list of loans that they expect to buy. However, savvy investors know that this modelled portfolio can vary markedly from the one which emerges in practice.

Another big uncertainty for equity investors, as for debt holders, is that they do not know how long the CLO will last. Although equity investors as a class control the call option, an individual equity investor does not, unless it owns a majority of the tranche.

Therefore, equity investors need to make assumptions about when the CLO will be called. The identity of other investors in the equity tranche could be critical to the timing of a call. Their willingness to call a CLO may depend on the kind of institution they are, their investment mandate, and the price at which they bought the position. Therefore analysing the equity investor base is an important part of valuing the equity.