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Analysis CLOs
Triple C assets and capital preservation
by Poh-Heng Tan
In the US and Europe, better performing CLOs tend to hold fewer triple C assets. But even so, a third of top performing CLOs in the US have more than 6% of their assets in the triple C bucket
In today’s strong loan environment, breaching the triple C limit may be viewed negatively by the market. However, it is usually a poor choice for managers to sell triple C assets purely to stay within the typical 7.5% threshold — or for cosmetic reasons. Not all triple C assets are alike, and higher asset prices offer managers flexibility in managing the triple C haircut adjustment for their overcollateralisation (OC) calculations.
1: European CLOs (2019-21 vintage): triple C exposures
Source: see methodology
Managing for future downgrades
CLO management is a long-term strategy rather than one focused on meeting short-term targets, such as avoiding an OC test breach for one or two payment periods. As a result, managers calculate the likelihood of future triple C downgrades when making trading decisions. This might involve detailed assessments of the downgrade and default risk of each asset over a period of, say, three-to-six months or a year, and estimating the overall impact on OC ratios. Projecting triple C downgrades is a valuable exercise because it encourages credit analysts to explore various scenarios and the probability of things going wrong. A thorough understanding of the rating agencies’ corporate credit rating methodologies would undoubtedly be beneficial.
What do investors prefer? Generally, they seek managers which maximise the value of the collateral pool, rather than selling triple C assets simply to reduce triple C exposure artificially or to gain short-term OC ratio advantages. Ideally, managers would also consistently steer clear of credits that become problematic.
2: US BSL CLOs (2019-21 vintage): triple C exposures
Source: see methodology
Evaluating performance by MVOC
One straightforward way to assess a manager’s capital preservation efforts is to examine the manager’s market value overcollateralisation (MVOC) performance, adjusted for the vintage effect. Primary and secondary market participants often focus on this number — a point in time metric — as it is important for pricing rated CLO tranches. Put another way, rated CLO tranches trade on the back of the loan market.
1
%
Number of worst performing deals in US with triple C exposure < 4%
Nothing is ever simple with CLOs though. A deal might begin with different initial levels depending on the leverage within the capital structure. This structure is shaped by factors such as the portfolio’s initial weighted average life limit, WARF (weighted average rating factor), recovery rates and diversification.
Moreover, it is important to note that the MVOC metric does not account for par distribution, which should be considered when evaluating a manager’s overall performance. Some managers can maintain a higher carry without negatively impacting their MVOC. A more comprehensive measure of a manager’s return performance, such as alpha, offers a clearer picture, but that’s a discussion for another time.
Nonetheless, MVOC remains a crucial metric for debt investors. One might argue that if a deal’s MVOC is higher at inception due to a conservative leverage structure, it could indicate that the portfolio is less diverse. But if a manager can sustain a solid MVOC over time while managing a less diverse portfolio, they deserve recognition for their effective risk management.
*222 European CLOs from 2019-21
**669 US BSL CLOS from 2019-21
Our sample of seasoned European deals
Starting in the European market, the charts in figure 1 (see above) divide the market into four quartiles based on MVOC metrics by asset prices as of 25 October 2024, adjusted for the vintage effect. We then look at how the triple C exposures vary for each tier of deals (see table 1, above). For this analysis we examined a sample of 222 European CLO deals from the 2019-21 vintages, selected because they have had time to season, with median triple C metrics across these vintages fairly consistent at around 5-6%.
So how strong is the correlation between MVOC and triple Cs? Interestingly, 31% of deals in the top MVOC quartile have a triple C exposure greater than 5%. In contrast, in deals with lower MVOC figures, that figure is greater (triple C exposure is above 5% in 59% of deals in the second quartile, 67% in the third quartile, and 79% in the fourth quartile). However, all these figures indicate that a deal can have relatively high triple C exposure while still performing well in terms of preserving the market value of the underlying collateral pool.
8
%
Number of top performing deals in US with triple C exposure > 7.5%
Would investors like a top-quartile deal by MVOC with high triple C exposure — or would they prefer a fourth-quartile deal with low triple C exposure? Ideally, they’d favour a top-quartile deal with low triple C exposure. But managers can always trade out of triple C assets, resulting in a lower triple C bucket. Notably, the median deal in the top MVOC quartile has a relatively low triple C exposure of 3.90%, compared to over 5% in other quartiles. The likelihood of a deal with very low triple C exposure falling into the third or fourth quartile is also considerably smaller.
In conclusion, there is a correlation between MVOC and triple C exposure. Deals with less than 3.0% exposure tend to perform well in terms of MVOC. Deals from the 2019-21 vintages with triple C exposures below 2.0% have demonstrated strong performance, as they appear to have avoided or exited problematic credits at an early stage.
31
%
Number of top performing deals in Europe with triple C exposure > 5%
Ultimately, the long-term, non-recourse term funding structure of a CLO vehicle gives managers significant asset holding power, which is a great advantage. CLO managers can afford to wait for the right opportunities to reduce their triple C exposure. CLOs rarely reach maturity as planned, as deals are typically refinanced or liquidated by the majority equity investors when the economics make sense. If a deal performs well, there is a much higher chance of it being reset without the need for new equity or a class X note, which would reduce future equity distributions. Debt investors in these deals should also be pleased to receive their capital back earlier, allowing them to reinvest the prepaid proceeds into today’s higher-spread CLO tranches.
A good recent example is RRE 3 Loan Management. This deal performed well and was recently reset, with its reinvestment end date extended from May 2024 to July 2029. Its WACC increased from the original 158 bps to 179 bps. Pre-reset, this deal had a triple C exposure of only 0.7%.
Impact of triple C exposure in US CLOs
Turning to the US CLO market, how does the relationship between MVOC and triple C exposure compare there (see figure 2, above)? Table 2 outlines the percentile of triple C exposure for each quartile, based on MVOC metrics and adjusted for the vintage effect. This analysis covers a sample of 669 US BSL CLO deals from the 2019-21 vintages.
The pattern is similar to Europe, but reflects the higher average triple C exposures seen in the US market. Deals with less than 4% triple C exposure tend to perform well. But as in Europe, a deal can also have a relatively high triple C exposure and perform well relative to its peers in preserving the market value of the underlying collateral. But while 19% of top-quartile deals and 4% of second-quartile deals have triple C exposure below 4%, only 4% of third-quartile deals and 1% of fourth-quartile deals fall into this category. Despite that, the fact that almost a third of top quartile US CLOs have triple C exposures above 6% demonstrates that triple C exposure alone does not fully explain capital preservation.
Deals from the 2019-21 vintages with less than 3.0% triple C exposure are likely to perform exceptionally, though such deals with low triple C exposure are rare.
Methodology
- Sources for all data are Intex, CLO Research and S&P Market Intelligence.
- Triple C exposure is the highest triple C basket as rated by Moody’s, S&P or Fitch.
- MVOC, for instance, at the double B tranche level, is calculated by dividing the collateral market value by the sum of CLO liabilities (from triple A to double B).
