By Douglas Lucas, Managing Director, SEDA Experts LLC
“Obligor overlap” refers to different collateralized loan obligations (CLOs) having the same loan obligors in their collateral asset portfolios. In this article, we show why obligor overlap is bad for equity tranche investors and good for debt tranche investors. In this respect, CLO industry practice favors the interests of CLO debt investors, as most CLOs have a high degree of obligor overlap with each other. In fact, CLO equity investors would have to look hard to find CLOs that own loans from very different sets of obligors. To reduce obligor overlap, CLO equity investors will have to insist that CLO managers change their collateral management practices.
The large number of loan obligors that CLO managers hold positions in, and the way CLO managers distribute loans across the CLOs they manage, creates loan obligor overlap. Across all the CLOs they manage, CLO managers typically own loans from over 300 and even over 400 loan obligors. Why such a high number of obligors? Because in a hot CLO market, CLO managers compete to buy loans. They often can’t buy the loans they want in the quantities they want and end up buying loans from obligors they otherwise might not have purchased. The managers end up with smaller positions in a greater number of loan obligors than they might like.
Then, when managers receive a loan allocation, they don’t put all the loan into a single CLO. Instead, managers typically divide its principal across all or several of the CLOs they manage. Over time, their CLOs gain more and more of the same loan obligors. Individual CLOs typically own loans from over 200 and even over 300 loan obligors. Within CLOs managed by the same manager, we found average obligor overlap to be 81% by principal. Across all managers, we found average obligor overlap to be 45% by principal (Lucas and Mathur).
The large number of common loan obligors across CLO collateral asset portfolios causes CLO performance to be more similar than it would be if CLO portfolios were more differentiated. To the extent CLO collateral performance is similar, it is bad for equity tranche holders and good for debt tranche holders. We’ll prove our point by discussing the extremes of obligor overlap, 100% overlap and 0% overlap.
In the 100% overlap case, all CLO-eligible loan obligors appear in every CLO collateral asset portfolio. Each CLO collateral portfolio is an index of all CLO-eligible loans and all CLOs experience the same default losses. In the 0% overlap case, CLO-eligible loans are divided among CLOs so that each loan obligor appears in only one CLO collateral portfolio. In aggregate, 0% overlap CLOs experience the same default losses as 100% overlap CLOs, but losses are distributed unevenly across the 0% overlap CLOs.
Say there have been a lot of default losses, so high that in the 100% overlap case, future collateral cashflows will only cover debt tranches, and equity tranches will receive no cashflow. In the 0% overlap case, collateral portfolios aren’t the same and default losses aren’t uniform. In some CLOs, equity tranches will receive cashflow and in other CLOs, debt tranches will sustain losses. It’s clear from this example that one would rather own a portfolio of CLO equity tranches from the 0% obligor overlap CLOs where some equity tranches will receive cashflow and some debt tranches will receive diminished cashflow. In contrast, one would rather own debt tranches from the 100% overlap portfolio where all debt tranches will receive full cashflow and no equity tranches will receive any cashflow.
Obligor overlap makes collateral losses more uniform across CLOs which is better for CLO debt. Differentiated collateral portfolios make collateral losses less uniform across CLOs which is better for CLO equity. CLO obligor overlap is unlikely to be reduced unless CLO equity tranche holders insist that managers change their practices and form more obligor-differentiated collateral portfolios.
Douglas Lucas has over 30 years of experience in the financial industry and is a world-class expert in fixed income and structured product credit risk. He created Moody’s CLO rating methodology, including the WARF and diversity score measures of portfolio credit risk. At UBS, he was for 8 years consistently voted onto Institutional Investor’s Fixed-Income Research Team for CLO and CDO research.
Doug Lucas worked at Salomon Brothers, JPMorgan, UBS, and Moody’s. He created Moody’s first default study and its CLO rating approach in 1989 (including WARF and Diversity Score metrics). At UBS, 2000-08, he was voted #1 for CDO research in Institutional Investor’s poll. From 2009 to 2018, he managed Moody’s most-read publication, responsible for 18% of Moody’s total research readership. Some of his articles on CLOs, CDOs, and other structured finance products; default correlation and credit analysis; and rating agency regulation can be found at independent.academia.edu/DouglasLucas2.
References
Lucas, Douglas J and Siddharth Mathur. “CLO Portfolio Overlap Déjà vu,” UBS CDO Insight, 29 September 2008.
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