CDO Structure Coverage Tests
- Coverage tests are meant to ensure that sufficient collateralization or interest coverage levels are maintained to protect a CDO's rated debt tranches.
- Coverage tests generally consist of par value tests (or collateralization tests) and interest coverage tests.
- A par value test typically seeks to maintain a minimum ratio of collateral portfolio amount to the par amount of CDO debt tranches.
- For example, in a Class A, collateral par value / par amount of the Class A notes >= X% (the par value coverage test ratio).
- An interest coverage test typically seeks to govern the ratio of interest proceeds from the collateral portfolio to the coupon payable on CLO debt tranches.
- For example projected interest proceeds generated by the portfolio / coupon due on the Class A notes >= Z% (the interest coverage test ratio).
- If a par value test or interest coverage test fails (usually because of credit losses on the collateral portfolio), on a payment date, cash flow is diverted in the priority of payments to pay down the principal balance of the debt tranches (typically sequentially) until the minimum required test level is restored.
- Such a diversion of cash flow can interrupt the payment of timely interest on subordinate debt tranches or the payment of distributions to the equity test.
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