Understanding the tests
- The other mechanism that protects debt investors in a CLO (besides the cashflow waterfall) is a series of tests relating to the quality and performance of the CLO.
- The collateral administrator checks the CLO’s compliance with these tests each month. If a test fails, the rules of the CLO change in some way – usually to the benefit of debt investors and at the expense of equity investors.
- The most important test for most CLOs is the overcollateralisation test. If it fails, the CLO manager generally has to stop making new investments and must use all available income to pay down the CLO notes.
- Overcollateralisation tests compare the par value of the CLO portfolio (adjusted for defaults and imminent defaults) with the par value of the CLO notes. This ratio must be above a predetermined threshold for the CLO to pass its overcollateralisation test each month.
Turn to the print version of this guide to find out:
- How overcollateralisation and interest coverage tests work in practice.
- How defaults affect the calculation of a CLO’s par value and its compliance with overcollateralisation tests
- The difference between the interest diversion test and the overcollateralisation tests
- How the CLO manager can increase or decrease the CLO par value by buying and selling assets
- How triple C buckets and discount purchase rules work and how they affect the par value of the CLO portfolio
- What other tests a typical CLO contains and how their failure constrains a manager’s actions
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