AND ALEX CALIGUIRI, CFA

Estimated reading time: 3 minutes

Introduction

A Collateralized Loan Obligation (CLO) is a type of structured credit product whereby a pool of corporate loans are securitized and divided into various investment tranches, each with different levels of risk and return potential. CLOs offer investors the opportunity to participate in the performance of a diversified pool of loans, providing exposure to a range of industries and borrowers at different risk levels and return targets depending on their specified tranche investment.  Typically, more risk-averse investors such as banks and insurance companies provide the lowest risk capital, the AAA-rated tranche, which comprises the majority of the CLO financing structure (typically 60% to 65%), whereas the riskiest, or lowest rated BB/B rated and equity tranches, are often held by more risk-averse hedge fund investors.

This case study delves into the dynamics of CLO investments, specifically focusing on the internal rate of return (IRR) comparison between CLO equity and BB-rated CLO debt. Our goal is to assess the ongoing validity of the long-term inter-tranche premium used by market participants, typically around 600 basis points (bps). Understanding this inter-tranche premium is necessary in order to properly value CLO equity tranches.

Analysis Methodology

In this section, we outline our data-gathering and analysis approach:

• Data Compilation: We collected and processed cash flow data from all BB-rated CLO tranches and CLO equity tranches issued between 2014 and 2021, as reported in the Intex platform.
• IRR Calculations: IRRs were calculated based on various entry and pay-off scenarios for BB and CLO equity tranches, providing a comprehensive view of their performance.
• Scenario Considerations: We explored six scenarios for CLO equity tranches, covering different purchase prices (85% of PAR value, 90% of PAR value, or Net Asset Value) and implied pay-off amounts (90% of NAV or 100% of NAV). Three scenarios were also analyzed for BB-rated CLO debt tranches, considering purchase prices of 97% of PAR value, 98.5% of PAR value, and 100% of PAR value, all with pay-offs at 100% of PAR value.

Comparative Analysis

This section presents the two most representative comparisons of our analysis:

Comparison #1: BB-rated CLO Debt vs. CLO Equity

We examine the IRR difference between purchasing BB-rated CLO debt at 98.5% of PAR value and CLO equity entry at 95% of PAR value with a pay-off at 100% of NAV.

This scenario reveals a median IRR difference of approximately 5.75%, closely aligning with the commonly used 5.5% to 6.5% long-term inter-tranche IRR premium.

Comparison #2: CLO Equity vs. BB-rated CLO Debt

This comparison evaluates the IRR premium between an equity purchase at 85% of PAR and pay-off at 90% of NAV against a BB-rated CLO debt purchase at 97% of PAR.

Results indicate a median IRR premium of approximately 7.25%.

Summary and Implications

In conclusion, our analysis of the IRR results offers valuable insights into the long-term premium associated with BB-rated CLO debt compared to CLO equity. The scenarios examined illustrate substantial IRR differences, ranging from approximately 5.0% to 7.0%.

Investors can use these insights to make informed decisions about CLO debt and equity valuation. Understanding the inter-tranche premiums since 2014 allows investors to assess the attractiveness and performance potential of CLO equity and BB-rated CLO debt.

This analysis provides a valuable resource for investors, offering deeper insights into the potential risk-reward dynamics within CLO investments. By considering these findings, you can enhance your investment strategies and optimize returns.

While our analysis provides valuable insights, it is essential to acknowledge certain caveats to our findings, including:

• We use median IRRs to manage outliers in the data effectively.
• Our reliance on data from the Intex platform limits the accuracy of our findings to information reported within that platform.
• In some cases, our analysis excludes refinanced CLOs, focusing primarily on the original vintages rather than the year of refinancing.
• Our analysis utilizes averages/medians across vintages, offering a broader perspective rather than a deal-by-deal basis for in-depth examination.
• The analysis is based on data available as of September 2023, providing up-to-date market insights for consideration.

These considerations are crucial, as they help to ensure a comprehensive understanding of the data’s limitations and potential impact on investment decisions, recognizing individual deal characteristics and the broader market context, conditions, and trends will vary.

As part of VRC’s Portfolio Valuation Practice Group, its dedicated Structured Products Valuation Team offers clients deep experience across the CLO/ABS industry. For a more in-depth conversation, we welcome you to contact article authors Shane Newell, Charles Paraboschi, or Alex Caliguiri or contact us with the details of your next engagement.