Global credit funds & CLO's
March 2020
| Issue 221
Published in London & New York.
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Investment managers invariably construct their strategies in order to generate trading profits, don’t they? It would be strange were they to pursue any other objective. But actually this is not always the case. Our research into the market for CLOs has uncovered powerful counter incentives that work against managers’ pursuit of this traditional and straightforward goal.
Read the full paper at; data source: CLO-i
What drives CLO performance?
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Research into CLO trading by professors Florin Vasvari and Maria Loumioti leads them to believe that, when CLOs are bound by strict constraints, managers tend to focus on ‘compliance trading’
These findings are, we believe, of great relevance to all who work in the CLO sector. They are likely to change the way some market participants view their industry, and this, in turn, could alter behaviour by both CLO managers and their investors.
One of the distinctive features of CLOs, compared to other securitised loan vehicles, is that CLO managers trade the underlying portfolio. They are able to buy and sell loans to offset adverse credit events, enjoying the discretion to rebalance up to 25% of the portfolio every year. The net effect of this is that the portfolio composition is constantly changing. To facilitate these portfolio shifts, CLO managers employ the private information to which they are privy as members of the loan syndicates in question, as well as the information gathered from their own due diligence on the underlying borrowers in the portfolio. Commentators attribute the consistently strong performance of CLOs in terms of low default rates and double-digit equity returns to the active management of CLO portfolios and to the constraints, or tests, that impose certain levels of portfolio credit risk exposure. Prior studies have shown that investment constraints on equity mutual fund portfolios have no material effect on returns to investors. However, there are key differences between the constraints applying to such funds and those imposed on CLOs.
CLO test restrictiveness versus equity returns
“Managers of more constrained CLOs tend to sell at steeper discounts”
For example, corporate loans are more informationally opaque compared to equities. This suggests that portfolio tests may play a more important role in CLOs than in equity mutual funds. Such constraints vary in relation to the portfolio characteristics desired by the key stakeholders: the CLO manager, equity tranche investors and noteholders, among others. The types of constraints are standard across the sector, but the restrictiveness with which they are applied varies greatly. As a general rule, tighter tests are applied to riskier portfolios.
Constraints on CLO portfolios
The most prominent CLO constraint is the capital coverage or over-collateralisation test. It sets a minimum figure for the ratio of the value of the CLO’s loan portfolio to the principal value of its outstanding debt tranches. A second constraint, the interest coverage test, is similarly designed to provide a margin of safety for the portfolio. It states that the interest generated by the assets in the CLO must be greater than the interest due on the CLO notes. With both capital and interest in the CLO safeguarded, two more tests relate to the quality of the portfolio. The first is the weighted average rating factor, which measures the level of credit risk in the portfolio and ensures that the weighted risk rating remains below a certain level. The second is the weighted average spread. It aims to ensure the average spread of the CLO’s portfolio loans is above a set threshold, ensuring the portfolio produces a minimum level of interest spread. Violation of portfolio constraints can have serious consequences for the structure of a CLO, for the investors and, of course, for the manager. There is a set period during which the breach of the tests must be rectified. Should this not happen, interest and principal payments to junior notes and the equity tranche are suspended, and cash is diverted to holders of the senior notes. The suspension of payments to junior noteholders and equity holders remains in force until the CLO is once again in compliance with the tests. Furthermore, the credit rating on the CLO’s notes can be downgraded and managers may not receive performance fees.
Investigating the effect of CLO tests
Using the four tests described above, we looked at the effect of differing degrees of strictness on CLO managers’ trading choices and investor returns. CLOs report loan-level information on a monthly basis regarding their portfolio structure, performance and trading activity. This allows us to identify the specific loans traded or retained in a CLO portfolio, as well as to look at the timing and pricing of CLO loan trades. All CLOs have to meet the same portfolio tests every month, so we were able to develop a common estimate of investment constraints across the CLO landscape. Once we estimated this scale of relative restrictiveness in relation to the four major constraints, we were able to make a preliminary investigation into how the strictness affects managers’ loan trading. It emerged that CLOs with more restrictive tests have higher portfolio turnover than those with looser constraints. They also have higher levels of diversification. Managers of these CLOs also held loans for fewer quarters and were more likely to rebalance their portfolios, buying a greater number of loans to offset the adverse effects of potential credit losses. In summary, such managers seem to rebalance and diversify their loan portfolios in order to avoid violations of the tests under which they have to operate.
Trading to meet tests can sacrifice the returns of the equity tranche
That is, perhaps, not especially surprising. But the behaviour of managers of more constrained CLOs in relation to bad credit-related news regarding a borrower is rather more notable and, again, arises in relation to the tests governing the CLO. On average, these managers are less likely to sell the loans of borrowers with credit-negative news in the prior quarter. Such sales would increase the likelihood of covenant violations. Of course, no manager can hang on to such loans forever. When they do sell, a second difference becomes apparent: managers of more constrained CLOs sell at a steeper discount. So, while they are less inclined to sell ‘bad news’ loans, when they do, it is often at a lower price.
Trading to alleviate losses
Here, we come to the central point with which we began: that there can be imperatives above and beyond generating trading profits. In the case of CLOs with strict tests, profit-seeking takes second place to the overriding need to comply with constraints. Indeed, it could be said that such managers are engaging in what we have described as ‘compliance trading’. What impact does this have on investors? That really depends on what sort of investors they happen to be. Our findings indicate that this trading pattern, which is designed to avoid a test violation, benefits noteholders. We document fewer CLO note downgrades and prepayments. In normal circumstances, the strategies pursued by managers of constrained CLOs — portfolio turnover, diversification and rebalancing — would be expected to benefit the equity tranche. But as managers of constrained CLOs strive to generate the short-term performance needed to meet the tests, they pursue trading strategies that have the effect of sacrificing the returns of that tranche.
The price of notes in the secondary market is linked to CLO restrictiveness
CLO investors have, to some extent, noticed this. The pricing of CLO notes and CLO equity in the secondary market shows a significant link to restrictiveness.

Our research draws no conclusion on the success or otherwise of the trading strategies of CLO managers operating under restrictive constraints. It is entirely possible that CLO equity returns would be even lower had managers employed different trading choices; indeed, they may have been lower even if there were no restrictive tests at all. Nor do we investigate the rationale for the widespread use of these portfolio tests in the CLO context.

We believe, however, that our research provides new and broad insights into the performance of CLOs. Specifically, it identifies the fact that stringent constraints provide an incentive for managers to screen and closely monitor their portfolios with a focus on alleviating losses on CLO notes, at the expense of generating equity returns. And this incentive, as previously mentioned, overrides the more conventional objective of generating trading profits.
Professor at London Business School
Florin Vasvari
Maria Loumioti
Assistant professor at University of Texas at Dallas
CLO managers don’t always prioritise profits
March 2020 | Issue 221
Analysis CLOs
by Florin Vasvari & Maria Loumioti
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