Collateralized Loan Obligations: A Structural Model for Pricing Tranche Spreads in a Corporate Loan Securitization

Abstract

In this paper, we analyze the source and magnitude of mispricing, if Collateralized Loan Obligation (CLO) tranches are rated as if the collateral pool has no prepayment risk, while the CLO investors price the tranches correctly, anticipating portfolio changes from collateral prepayments. The paper provides an example of an European CLO structure and its lifecycle. By adapting existing structural credit risk models, we create a framework for pricing CLO tranche spreads. Specifically, we model two cases: a base case without prepayments and a case with prepayment and make the assumption that rating agencies do not incorporate prepayment risk in their rating methodology. Using this assumption, we find a ”mispricing” in line with the excess spreads between CLO tranches and equivalently rated corporate bonds observed in empirical data. When making parameter assumptions lowering the prepayment rate, e.g., loan rating changes or increasing refinancing costs, we find that the mispricing decreases and vice versa.