While Aristotle may have coined the phrase “the whole is greater than the sum of its parts” we doubt that he was thinking about CLOs.
But sometimes the opposite is true: the sum of the parts is greater than the whole. This can happen when a company is acquired and then sold off in pieces that are more valuable than the purchase price of the company. Recently, some CLO market participants have suggested the same may be true for CLO debt when structured with specific features that are described in this article.
In a typical CLO structure, a pool of loans is aggregated and notes backed by the pool are sold to investors in debt and equity tranches reflecting varying levels of risk/reward. The debt tranches are typically floating rate instruments. Unlike many other securitized products, CLOs are actively managed by a collateral manager that buys and sells loans in and out of the collateral pool (subject to satisfaction of certain tests agreed upon in advance) throughout a reinvestment period (typically four to five years) in order to build value for the CLO. Typically, CLOs have a call feature which is available to the equity investors and collateral manager after a two- to three-year non-call period. This call feature, which provides the flexibility to refinance some or all of the CLO debt tranches with less expensive debt, is usually exercised, and a related refinancing occurs, when CLO liability spreads tighten – namely, at times when debt investors who are repaid may only (all else equal) purchase similarly rated debt yielding lesser returns.
As a result, a CLO refinancing is typically undesirable for debt investors. If CLO liability spreads widen, there is no economic reason to exercise the call and, as a result, a refinancing will not occur and the CLO debt investors are left with the returns they agreed to at the time of the CLO closing, even though the market has shifted and they could obtain better returns from similarly rated debt in the current new-issue market.
Recently, a new structure has emerged in the CLO market called MASCOT (Modifiable and Splittable/Combinable Tranches) which is intended to partially mitigate the negative impact to holders of CLO debt associated with the call feature described above. A CLO note with a MASCOT structure provides a CLO debt investor with the post-closing flexibility to split its CLO note into parts: an interest-only MASCOT note which pays only interest at a fixed rate (solely from CLO interest proceeds) and a principal and interest MASCOT note which pays all of the principal of the pre-split note plus the portion of the pre-split note interest that is not stripped off to the related interest-only MASCOT note.
This concept is closely analogous to one used in the residential mortgage bond market in which MACRs (Modifiable and Combinable REMICs) offer similar flexibility. The aggregate of the amounts paid to the subparts (or splits) is equal to the amount that would be paid to the pre-split note. The splits can subsequently be reconsolidated into the pre-split note or reconfigured into various other combinations that have been determined at the time of closing. Each potential interest-only MASCOT note and principal and interest MASCOT note is assigned a CUSIP and a rating by a nationally recognized statistical rating organization at the time of closing regardless of whether any such split MASCOT notes are actually issued at closing. In fact, a recent CLO offering included a possible twenty-nine (29) pre-rated MASCOT combinations.
If a holder continues to hold its original note intact (or holds both original parts of its split MASCOT note), its value is unchanged. The sum of the parts is equal to the whole. However, even though the amount of principal and interest payable on the pre-split note and the aggregate of the principal and interest payable on the split notes is the same, under certain circumstances the investor may be able to increase the value of its note by splitting it apart and selling off one or both parts, such that the sum of the parts would be greater than the whole.
A typical fixed rate bond increases in value as interest rates decline because the currently above market interest rate of the bond makes it more valuable. And this is true to a limited extent with an interest-only MASCOT note. But CLOs (like mortgage bonds) have a characteristic called negative convexity as they have a greater tendency to be repaid when interest rates decline (or spreads tighten). As a result of this competing force, fixed rate bonds with negative convexity generally experience less of an increase in price as interest rates fall or spreads tighten than a typical fixed rate bond. So an interest-only MASCOT note is intended to behave differently than a typical fixed rate bond because MASCOTs are tied to the original CLO and its call feature.
If interest rates decline (or spreads tighten) enough and the non-call period has ended, the interest-only MASCOT note has a higher likelihood of being called in a refinancing of the original class of debt from which it is derived. In this case the interest-only MASCOT note is refinanced away.
However, the benefit of the MASCOT structure may help investors partially mitigate and/or isolate some of this negative convexity risk, which may include trading such risk to investors who see particular investment opportunities in such risk. An interest-only MASCOT note becomes more valuable the longer it exists and isn’t refinanced away because the value of the entitlement to interest payments increases the longer the interest payments are required to be made. So an interest-only MASCOT note will increase in value as spreads widen, which can make an interest-only bond desirable as a partial hedge for the negative convexity of a principal and interest bond.
Of course, the MASCOT structure raises documentation and operational considerations, a few of which are mentioned here. First, the voting rights of holders of MASCOT notes (particularly holders of the interest-only MASCOT notes in connection with proposed indenture amendments) will need to be considered, as collateral managers will have an interest in ensuring that the MASCOT structure doesn’t impede the administration of the transaction or optionality around refinancings and redemptions.
Second, ERISA restrictions will need to be considered: because of the difficulty of tracking compliance with the 25% percent limitation under the Plan Asset Regulations as holders split and reconstitute tranches notes, ERISA restricted classes that are MASCOT eligible may need to restrict or prohibit investment by benefit plan investors. Third, the CLO trustee must track all original notes and potential combinations. Finally, CLOs typically issue deferrable interest notes that capitalize deferred interest, which introduces some technical documentary documentation complexity in relation to the interest-only MASCOT notes, which have a notional amount rather than an entitlement to repayment of principal.
In addition, the tax treatment of MASCOT notes needs to be considered and may impact value. While the splitting of a MASCOT note should not itself be a taxable event, the sale by a holder of less than all of the split notes may require allocation of basis among the split MASCOT notes, recognition of gain or loss with respect to the sold note and/or treatment of the retained split MASCOT note as having original issue discount.
If investors attribute sufficient value to the benefits of the MASCOT structure to justify the additional complexity, and CLO participants are able to satisfactorily resolve any related documentary and operational considerations, one would expect (all else equal) to see tighter spreads on MASCOT classes at closing than for non-MASCOT CLO notes.
Whether, and the extent to which, the sum of the MASCOT parts is greater than the whole in the case of CLO debt remains to be seen.
