CLO Coverage Tests: OC and IC Explained

Coverage tests—specifically Overcollateralization (OC) and Interest Coverage (IC) tests—are the primary structural protections that have enabled CLOs to achieve zero AAA defaults over 30 years. These tests automatically divert cash flows from junior tranches to senior tranches when portfolio quality deteriorates, deleveraging the structure and protecting senior investors.

Core Purpose

Coverage tests answer: "Is there enough asset value and income to support the debt?" If the answer is no, cash flows are redirected to pay down senior debt until the answer becomes yes.

Overcollateralization (OC) Tests

Definition

The OC test measures whether the par value of assets is sufficient to cover the par value of liabilities at each tranche level.

Formula:

OC Ratio = (Par Value of Collateral) / (Par Value of Liabilities Through That Tranche)

Example: AAA OC Test

Scenario: $500M CLO with $300M AAA tranche.

  • Assets: $500M loan portfolio (par value)
  • Liabilities: $300M AAA tranche
  • AAA OC Ratio: $500M / $300M = 167%
  • AAA OC Trigger: 130% (specified in indenture)
  • Status: PASS (167% > 130%)

What happens if $50M of loans default and are written down to $10M?

  • New asset value: $500M - $50M + $10M = $460M
  • New AAA OC Ratio: $460M / $300M = 153%
  • Status: Still PASS (153% > 130%)
  • Result: No cash diversion; AAA remains protected

What if defaults reach $80M with $16M recovery?

  • New asset value: $500M - $80M + $16M = $436M
  • New AAA OC Ratio: $436M / $300M = 145%
  • Status: Still PASS (145% > 130%)

What if defaults reach $120M with $24M recovery?

  • New asset value: $500M - $120M + $24M = $404M
  • New AAA OC Ratio: $404M / $300M = 135%
  • Status: Still PASS (135% > 130%)

What if defaults reach $150M with $30M recovery?

  • New asset value: $500M - $150M + $30M = $380M
  • New AAA OC Ratio: $380M / $300M = 127%
  • Status: FAIL (127% < 130%)
  • Result: Cash trap activates. Interest and principal that would go to equity/mezzanine is diverted to pay down AAA tranche.

Multiple OC Tests (Cascading Protection)

CLOs don't have just one OC test—they have an OC test for each tranche:

Tranche Typical OC Trigger Interpretation
AAA 127-132% Assets must be 27-32% > AAA liabilities
AA 118-122% Assets must be 18-22% > (AAA + AA) liabilities
A 113-117% Assets must be 13-17% > (AAA + AA + A) liabilities
BBB 108-112% Assets must be 8-12% > (AAA through BBB) liabilities
BB 103-107% Assets must be 3-7% > (AAA through BB) liabilities

Key insight: Senior tranches have more cushion (higher triggers), while junior tranches have tighter triggers. This means BBB/BB tests fail first, triggering cash diversions before AAA is at risk.

Interest Coverage (IC) Tests

Definition

The IC test measures whether interest income from the loan portfolio is sufficient to pay interest expenses on the debt tranches.

Formula:

IC Ratio = (Interest Income from Collateral) / (Interest Due on Liabilities Through That Tranche)

Example: AAA IC Test

Scenario: $500M CLO earning SOFR + 450 bps; $300M AAA tranche costing SOFR + 135 bps.

  • Annual interest income: $500M × 9.5% (SOFR 5% + 450 bps) = $47.5M
  • Annual AAA interest expense: $300M × 6.35% (SOFR 5% + 135 bps) = $19.05M
  • AAA IC Ratio: $47.5M / $19.05M = 249%
  • AAA IC Trigger: 125% (specified in indenture)
  • Status: PASS (249% > 125%)

What if loan spreads compress to SOFR + 400 bps?

  • New interest income: $500M × 9.0% = $45.0M
  • AAA IC Ratio: $45.0M / $19.05M = 236%
  • Status: Still PASS (236% > 125%)

What if $100M of loans are downgraded to CCC (valued at 75 cents for test purposes)?

  • Effective collateral for IC: ($400M × 100%) + ($100M × 75%) = $475M
  • New interest income: $475M × 9.5% = $45.1M
  • AAA IC Ratio: $45.1M / $19.05M = 237%
  • Status: Still PASS

What Happens When Tests Fail?

The Cash Diversion Mechanism

When OC or IC tests fall below their triggers, the CLO activates a "cash trap":

  1. Interest payments diverted: Interest that would normally go to equity and mezzanine tranches is instead used to pay down senior tranches early.
  2. Principal payments diverted: Principal proceeds (from loan repayments or sales) are used to pay down senior tranches rather than being reinvested in new loans.
  3. Deleveraging: The CLO shrinks its senior debt, increasing the OC/IC ratios until tests are cured.
  4. Junior tranches cut off: Equity and junior debt receive $0 until tests pass again.

Real-World Example: 2008-2009

CLO XYZ (2007 vintage):

  • Q4 2007: All OC/IC tests passing. Equity receiving $4M quarterly distributions.
  • Q2 2008: Portfolio downgrades accelerate. BBB OC test fails (109% vs. 111% trigger).
  • Action: Cash trap activates. $3M that would go to equity + BBB interest is diverted to pay down AAA tranche.
  • Q3 2008: Defaults rise. AAA OC test approaches trigger (131% vs. 130% trigger).
  • Action: All available cash (including principal proceeds) used to pay down AAA/AA tranches.
  • Q4 2008 - Q4 2009: Equity receives $0 for 5 consecutive quarters. AAA tranche paid down from $300M to $265M.
  • Q1 2010: Economy recovers, portfolio stabilizes. AAA OC test rises to 138%.
  • Q2 2010: Tests cure. Equity distributions resume (reduced due to smaller portfolio size).

Outcome: AAA investors received 100% of scheduled payments. Equity investors lost 18 months of distributions but avoided total loss.

Par vs. Market Value: A Critical Detail

Most CLO OC tests use par value, not market value, with specific adjustments:

Par-Based Valuation Rules

  • Performing loans: Counted at 100% of par (face value), even if trading at 95 or 105 in secondary market.
  • CCC-rated loans: Haircut to 70-85% of par (varies by deal).
  • Defaulted loans: Marked to recovery value (typically 20-40% of par until workout).

Why Par-Based Tests?

Advantage: Protects against short-term market volatility. A loan trading at 90 due to technical factors (not credit deterioration) still counts at 100 for OC purposes.

Risk: A loan fundamentally impaired but not yet defaulted may still count near par, delaying test failures.

Mitigation: Rating-based haircuts (CCC = 70-85 cents) force recognition of deterioration before default.

How Coverage Tests Prevented AAA Defaults in 2008

The Mechanism in Action:

  1. 2007-2008: Loan portfolios experienced 6-10% defaults (2008-2009).
  2. Early warning: OC/IC tests began failing for mezzanine tranches (BBB/BB) in Q4 2007-Q1 2008.
  3. Cash diversion: $10-15B of cash flows that would have gone to equity/mezzanine were diverted to AAA/AA tranches across the CLO market.
  4. Deleveraging: AAA tranches were paid down 10-20% (from $300M to $240-270M typical), increasing subordination cushion.
  5. Result: By the time peak defaults hit in 2009, subordination had increased (not decreased), protecting AAA tranches from impairment.

Without coverage tests: AAA tranches would have continued paying interest to equity while asset values declined, resulting in likely AAA impairments. With coverage tests: Zero AAA defaults.

Test Frequency and Curing

Testing Schedule

  • Frequency: OC/IC tests are calculated monthly or quarterly (specified in indenture).
  • Reporting: Published in monthly trustee reports.
  • Immediate effect: If a test fails, cash diversion begins at the next payment date (typically within 30-90 days).

How Tests Cure

Tests can cure through multiple mechanisms:

  • Deleveraging: Paying down senior debt increases OC ratios (smaller denominator).
  • Portfolio improvement: Manager sells deteriorated loans, buys higher-quality loans.
  • Rating upgrades: CCC loans upgraded to B count at 100% instead of 75%, increasing asset value.
  • Recovery proceeds: Defaulted loans recover more than expected, boosting asset value.
  • Time: As defaults are realized and written off, uncertainty decreases and valuations stabilize.

Duration of Test Failures

Scenario Typical Duration of Failure Impact
Technical failure (brief downgrades) 1-3 quarters Minimal cash diversion; tests cure quickly
Moderate stress (e.g., sector-specific) 4-8 quarters Equity/mezzanine receive zero distributions; eventual cure
Severe stress (e.g., 2008-2010) 8-16 quarters Extended zero distributions; may require portfolio restructuring
Permanent impairment Never cures Equity wiped out; mezzanine may experience principal losses

Coverage Tests by Tranche

Impact on Different Investor Classes

Investor Test Failure Impact Protection Level
AAA Investors Continue receiving full interest; benefit from early paydown (if desired) or extended maturity (if preferring duration) Extremely high—tests are designed to protect AAA first
AA/A Investors Continue receiving interest unless their specific OC/IC tests fail (rare); may see accelerated paydown Very high—subordination provides substantial cushion
BBB Investors Often first to experience interest payment deferrals; cash diverted to senior tranches Moderate—12-18% subordination below them
BB Investors High likelihood of interest deferrals; may experience principal write-downs in severe scenarios Lower—only equity below them
Equity Investors Distributions cease immediately upon any test failure; resume only after all tests cure None—first to absorb all losses

Advanced Topics: Test Gaming and Manager Strategy

Can Managers "Game" Coverage Tests?

Window dressing: Managers might temporarily improve portfolio quality before test dates.

  • Example: Sell CCC loans (which count at 75 cents) and buy B loans (which count at 100 cents) before month-end test calculation.
  • Limitation: Must comply with diversity and concentration limits; can't materially change portfolio composition.
  • Market discipline: Sophisticated investors monitor monthly holdings and detect gaming.

Strategic Trading Around Tests

Smart managers proactively trade to avoid test failures:

  • Sell deteriorating credits early: Sell at 85-90 before they hit CCC or default (avoiding 75-cent haircut).
  • Upgrade portfolio quality: Swap B-rated for BB-rated loans to improve WARF and provide OC cushion.
  • Capture spread: Use proceeds from loan sales to buy higher-spread loans, improving IC tests.

Key Takeaways

OC Tests

  • Measure: Asset value vs. liabilities
  • Par-based (with CCC haircuts)
  • Typical AAA trigger: 127-132%
  • Failure = cash diversion to pay down debt

IC Tests

  • Measure: Interest income vs. interest expense
  • Typical AAA trigger: 120-130%
  • Sensitive to loan spread compression
  • Failure = cash diversion to pay down debt

Why They Work

  • Automatic triggers (no manager discretion)
  • Early warning system
  • Self-healing through deleveraging
  • Protected AAA for 30 years

Investor Impact

  • AAA: Protected, may benefit from early paydown
  • BBB: First to experience deferrals
  • Equity: Distributions cease during failures
  • Duration: 1-16 quarters typical

Further Reading

Disclaimer

This content is educational only. CLO structures vary by deal. Investors should review specific offering documents for exact OC/IC trigger levels and test methodologies. Coverage tests do not eliminate risk.