In a collateralized loan obligation, howis protection afforded to the most senior bond class?

Question

What will be an ideal response?

Answer 1

A collateralized loan obligation (CLO) is a special purpose vehicle (SPV) that issues debt and equity and from the funds raised invests in a portfolio of leveraged loans. The entity responsible for managing the portfolio of leverage loans (i.e., the collateral) is the collateral manager. Protection is provided to the most senior bond class in a collateralized loan obligation because this class has senior claims enforced by the rules for the distribution of collateral interest and collateral principal. These rules for the distribution of collateral interest and collateral principal, referred to as the cash flow waterfalls, specify the order in which bond classes get paid and by doing so enforce the seniority of one CLO creditor over another.

Another key feature of a CLO is the coverage tests set forth in the indenture. They are important because the outcomes of thesetests can result in a diversion of cash that would have gone tothe subordinated bond classes and redirect it to senior bond classes. In addition, it is important to understand that there is a period of time in which collateral principal is not distributed to the bond classes or the equity tranche but instead reinvested by the collateral manager by purchasing additional loans. This time period is referred to as the reinvestment period.

More details are provided below about the classes or tranches.

Investors in the debt securities that the SPV issues — referred to as bond classes or tranches — are entitled to the cash flows from the portfolio of loans. The cash flow is distributed to the bond classes in prescribed ways that take into account the seniority of those liabilities. The rules described for the distribution of the cash flow are set forth in the CLO's indenture. In addition to the bond classes, there is a security called the equity tranche that is entitled to receive the residual cash flows.The liability structure of a CLO is referred to as its capital structure. These bond classes are commonly labeled Class A, Class B, Class C, and so forth going from top to bottom of the capital structure in terms of their priority and their credit rating. They run the gamut from the most secured AAA rated bond class to the lowest rated bond class in the capital structure. Class A in the capital structure, the one with the AAA rating, is referred to as the senior bond class. The other three bond classes are referred to as subordinate bond classes. Notice that in a typical CLO, the coupon rate floats with a reference rate (most commonly LIBOR).