How are CLOs priced?
- The value of a CLO note or equity tranche is equal to all its future payments discounted back to the present at an appropriate discount rate. The tricky part is that the discount rate needs to take account of the probability of receiving those cashflows.
- Like anything, a CLO is worth the price the market is prepared to pay for it. To make a comparison between CLOs or between CLOs and other bonds, investors need to convert prices into yield or spread terms. The standard measure of spread for floating rate bonds is the discount margin.
- To figure out the likely future performance of a CLO, an analyst needs to understand the rules of that particular CLO and to make assumptions about the default rate, recovery rate and prepayment rate of the CLO portfolio.
Turn to the print version of this guide to find out:
- Why the concept of weighted average life is crucial for making sense of the value of a CLO tranche.
- How to calculate a discount margin
- What standard assumptions are used for defaults, recoveries, repayment rates and reinvestment spreads and the limitations of these assumptions.
- How Libor floors and post-reinvestment purchases complicate the valuation of CLO notes and equity.
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