We conclude this chapter with a discussion of commonly used optional redemption features in CDO transactions. The most common is that the deal is callable at par by the equity holders, after a prespecified lockout.
The call is generally exercised when the deal is doing very well, and the col- lateral can be liquidated at a healthy net profit. The deal is more apt to be called when the spreads on the debt tranches have narrowed. That is, the
Interest Rate Cap Counterparty
Maximum of zero &
LIBOR minus fixed rate
CDO Debt Tranche
Holders LIBOR-based
coupons
Fixed rate coupons Collateral
Assets
c02-Cash Flow CDO Page 38 Monday, March 6, 2006 11:12 AM
market, call provisions can be important to the valuation of the securities.
Call Protection for Bond Investors
There are many different variations of the basic CDO structure in which the deal is callable at par after a preset lockout period. Two of the most common variations protecting bondholders are prepayment penalties and coupon step-ups.
Prepayment penalties can take two forms: Either the investor is com- pensated with a premium call, or there is a “make-whole” provision. The most typical premium call is an amount equal to one-half the annual cou- pon, which steps down over time. Essentially, the effect of the prepayment penalties is to make the call less attractive to the asset manager.
Coupon step-ups are somewhat rare in deals. If the tranche is not called on a certain date, the coupon “steps-up” to a higher level. A coupon step-up is only used if the asset manager wants to signal to investors that it is unlikely that the deal will extend beyond a certain point. For example, deals backed by collateral with long legal final maturities are more apt to have a coupon step-up to quell investor concerns about extension risk.
Variations of Call Provisions that Benefit Equity Holders
Not all call provisions will be exercised because the deal is going well.
Sometimes if the deal is going very poorly, the equity holders may choose to liquidate because the deal is worth more “dead” than alive.
This is particularly true towards the end of the deal because the expenses of running a small deal with low leverage are too high and a
“clean-up call” is beneficial.
There are also customized call provisions to protect the equity holders from the whims of an asset manager. Some CDO deals have “partial calls,”
which allows each group of equity holders to exercise authority over their own piece of the deal. This is different from typical structures, in which the deal is only callable in whole by a majority of the equity interests. It is clear that the value of the deal on an ongoing basis will be different for the asset manager (who earns management fees) and an equity holder (who does not). In certain rare cases, a majority of equity holders may replace the asset manager. This is most common in those deals in which the asset man- ager does not own a piece of the equity. Both of these call provisions are meant to protect the equity holder (who is not the asset manager) at the expense of the asset manager.
c02-Cash Flow CDO Page 40 Monday, March 6, 2006 11:12 AM
Two PART
Loans and CLOs
p02 Page 42 Monday, March 6, 2006 11:13 AM
CHAPTER 3
43
High-Yield Loans: Structure and Performance
igh-yield corporate loans are an important source of collateral for U.S.
collateralized debt obligations (CDOs). In each of the years 2001 through 2005, high-yield loans (also known as leveraged loans) have made up one-fourth to one-third of arbitrage cash flow CDOs. And col- lateralized loan obligations (CLOs) backed by high-yield loans have out- performed CDOs backed by other forms of corporate debt such as high- yield and investment grade bonds. This is correctly attributed to the supe- rior credit performance of loans and the conservative structure of CLOs.
Yet many CDO investors are unfamiliar with high-yield loans.
In this chapter, we attempt to fill that knowledge gap by answering the following questions:
■ What exactly is a “loan”?
■ How do lenders maintain their senior interest in the borrower’s assets?
■ How are borrowers prevented from taking actions detrimental to lender’s interests?
■ What are the trends in loan market size, spreads, and terms?
We also review historical evidence of loan credit quality. Compared to corporate bonds, loans are less likely to default and have higher recov- eries if they do default. We think this is because, relative to bond rat- ings, ratings on loans are more timely and accurate. These factors have led to the excellent credit performance of CLOs.
However, quantitative measures of risk and reward for recently issued loans have been mixed. Over the last two-and-a-half years, borrower lever-
H
We thank Jonathan Sprague for his help in this chapter.
44 LOANS AND CLOs
age has increased while loan spreads have decreased. But loan default rates are at historic lows, and run much lower than those of high-yield bonds.
And the floating rate nature of loans makes them attractive at a time when interest rates are expected to rise and ideal to support the floating rate lia- bilities of a CLO. Given these contradictory factors, it is a good time for investors to better familiarize themselves with high-yield loans and CLOs.