Managing Market and Liquidity Risk in the CLO Context

What is YTM and Macaulay Duration, and why is it important when assessing the value you should pay for a bond?

YTM - Yield to Maturity, the annualised returns an investor can expect over the life of a bond

Macaulay Duration - The weighted average time to maturity of the cash flows of a bond. This is a useful concept for CLOs as they do not have bullet repayments, but which are instead paid down over time as cash is received on the underlying portfolio.

Why is it important?

For example: a bond's original par price = £100, with a yield to maturity of 3%, and the duration of 5 years. Hence, the current price of the bond is par or 100. If duration is extended to 7 years, this means the original par price of the bond is 100, YTM is 4%, and the current price of the bond would move down to 75.99. The investor assessed that the previous expectation of a 5 year duration was incorrect, and in order to move the YTM to the more appropriate 4%, the price of the bond came down.

What can alter the speed of repayment of bonds?

1. Prepayment and repayment rates on the loans
2. The ability to pay coupons on time
3. The level of defaults and recovery levels
4. The time it takes to recover money on defaults
5. The likelihood that the equity holders will call the transaction or that an investors particular tranche could be refinanced

What is Modified Duration, and why might it be inaccurate?

Modified Duration - The amount that the bond value will change for every basis point move in the TYM of a bond.

Why is it inaccurate?

It relies on an efficient market to give an accurate YTM which doesn’t exist in structured credit, especially not in times of market distress. Modified duration is therefore, an indicator of price sensitivity at one point in time, as liquidity levels change, the sensitivity of the bond changes, and thus, it’s not a predictor of all future price movements.

How do CLOs mitigate MTM volatility?

The underlying loans are not mark-to-market on the CLO balance sheet. CLOs have committed funding (the bonds issued) for the full life of any underlying assets in their portfolios. The CLO Manager is therefore never forced to sell a loan in a bad market environment, which means they are never forced to crystalise a MTM loss. This is also one of key reasons there were so few CLO bonds that defaulted in the credit crisis.

However, where an investor has to MTM their own portfolio, and is paid fees based on the value of that portfolio, or even could be forced to sell assets because of funding requirements, this is a key risk.

Why is YTM unpredictable?

• YTM will change with a change in the Macaulay Duration
• YTM will change with a change in the perceived risk of the bond for factors other than Macaulay Duration. Examples of these include: high default rates, low recovery rates, poor performance of the collateral manager, market crashes and additional capital requirements

What may happen if an investor has leverage on their investments?

• The pain of any MTM reduction in valuation will be magnified
• The leverage may be taken away by the institution providing it, thus forcing the investor to sell the bond at the worst possible time

How is liquidity affected in the CLO market during stress times?

The CLO market has a high chance of not remaining liquid in times of stress as the banks tend to stop trading in these markets. This means that there are less bids and offers in the market, making the correct or fair price of a bond harder to discover. This can mean that TYM changes are much larger in times of stress than would otherwise be experienced.

What does an investor in CLO bonds need to be aware of?

Liquidity on a number of levels:

1. The underlying loans in assessing the ease of sale as a recovery option post a loan default
2. The Liquidity of your bond investment if you need to sell as a result of:
   • A breach of your investment mandate
   • You running out of cash
   • Your funder running out of cash
   • The market running out of cash

How do you hedge against liquidity risk?

• Keep your leverage/funding at a low level as possible. Lower leverage will give you more time in a crisis
• As near as possible, match your funding term with investment term, longer funding is better