United States: CLO Investors Benefiting From 'MASCOT' Note Flexibility

Last Updated: October 16 2019
Article by Joanna Nicholas

Bylined article by Banking & Finance counsel Joanna Nicholas (New York).

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.

Originally published in Asset Securitization Report

Visit us at mayerbrown.com

Mayer Brown is a global legal services provider comprising legal practices that are separate entities (the "Mayer Brown Practices"). The Mayer Brown Practices are: Mayer Brown LLP and Mayer Brown Europe – Brussels LLP, both limited liability partnerships established in Illinois USA; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales (authorized and regulated by the Solicitors Regulation Authority and registered in England and Wales number OC 303359); Mayer Brown, a SELAS established in France; Mayer Brown JSM, a Hong Kong partnership and its associated entities in Asia; and Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. "Mayer Brown" and the Mayer Brown logo are the trademarks of the Mayer Brown Practices in their respective jurisdictions.

© Copyright 2019. The Mayer Brown Practices. All rights reserved.

This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions