Leveraged Finance: Concepts, Methods, and Trading of High-Yield Bonds, Loans, and Derivatives

CHAPTER 5

CLO Returns

In the previous chapter, we described the fundamental of collateralized loan obligations (CLOs). In this chapter, we look at CLO returns. We begin by investigating the resiliency of CLO returns to defaults and recoveries. More specifically, we analyze 1,575 tranches from 340 CLOs issued from 2003 to 2007 that are covered by Moody’s Wall Street Analytics (MWSA) modeling service. Although when modeling CLO returns, the focus is primarily on defaults and recoveries, when there is dislocation in the credit markets, two other factors demand attention: (1) the size of the CLO’s triple-C asset bucket and (2) the price at which the CLO reinvests in new collateral loans. We investigate those factors in the second part of the chapter.

DEFAULT AND RECOVERY SCENARIOS

Table 5.1 shows the 26 default and recovery scenarios we made in modeling the CLOs using MWSA. In modeling CLOs, defaults can be quantified in a number of ways. The conditional default rate (CDR) is the annualized value of the unpaid principal balance of newly defaulted loans over the course of a month as a percentage of the total unpaid balance of the pool at the beginning of the month. Note in Table 5.1 that when we test CLOs with higher CDRs, we also stress them with lower loan recoveries in the event of default. We also specify bond recoveries for those CLOs that are allowed to invest a portion of their portfolios in those assets.

In creating our scenarios, we attempted to correlate default and recovery ...