Interest Diversion Test
Definition
The interest diversion test is a coverage test in a CLO indenture that measures the collateral par against the par of every rated note class, the same ratio as the most junior overcollateralization (OC) test, but with a trigger set a little higher. It applies during the reinvestment period. When the ratio falls below the trigger, a stated portion of the interest proceeds that would otherwise be paid to the subordinated notes, usually 50 percent, is diverted and reinvested in additional collateral. It is the CLO's early warning: it starts rebuilding par before the junior OC test fails and starts paying down notes.
Why it matters
The interest diversion test is the first coverage test a deteriorating CLO trips, and it is the one that hits the equity directly. Every dollar diverted is a dollar the subordinated notes do not receive that quarter. For an investor in CLO equity, or in a fund that holds it, the distance between the current ratio and the diversion trigger, the cushion, is the single best short-term indicator of whether the next distribution arrives in full. It also explains behavior that looks odd from outside: managers buying discounted loans in a sell-off are often spending diverted interest, which is exactly what the test was written to make them do.
Common misconceptions
- •It is not the same as an OC test failure. Both use the collateral-to-notes ratio, but an OC failure repays notes and deleverages; an interest diversion failure buys collateral and keeps leverage. The diversion trigger is set higher, so a deal can be diverting while every OC test still passes.
- •Diversion does not mean the equity gets nothing. The typical mechanic diverts a percentage, most often 50 percent, of the interest left after the notes and fees. The rest is still distributed.
- •A turbo is not a diversion test. A turbo pays down notes with excess interest; it is a deleveraging feature, and in some deals it runs on a schedule rather than a test result.
- •Passing the test does not mean the pool is healthy. The ratio uses par, with defaulted loans at recovery value and excess CCC loans at market value. A pool full of performing loans trading at 85 can pass every coverage test until downgrades move loans into the CCC haircut.
Technical details
How the ratio is measured
Numerator: the adjusted collateral principal amount, which is the par of performing loans, plus principal cash, minus haircuts: defaulted loans counted at the lower of market value and an assumed recovery rate, excess CCC loans at market value, and discount-purchased loans sometimes at purchase price.
Denominator: the aggregate outstanding principal of all rated note classes, senior through the most junior rated class (Class E in a typical five-class structure).
Trigger: set in the indenture above the junior OC trigger. Illustration for a deal with a Class E OC trigger of 104.0 percent: an interest diversion trigger of 105.0 to 105.5 percent. The gap is the point of the test.
Timing: calculated on each determination date during the reinvestment period and applied on the following payment date.
What happens on a failure
Interest proceeds flow down the waterfall as usual: senior fees, senior note interest, mezzanine interest, junior note interest, junior management fee.
At the interest diversion step, a stated percentage of the remaining interest proceeds, commonly 50 percent, is transferred to the principal collection account and treated as principal proceeds available for reinvestment.
The manager buys additional collateral obligations with it, subject to the same eligibility criteria and the collateral quality and portfolio profile tests as any other purchase.
The remainder of the interest proceeds continues to the subordinated notes and the incentive fee steps.
Diversion continues on each subsequent payment date until the ratio is back at or above the trigger; the test is then said to be cured.
Turbo features and how they differ
A turbo applies excess interest to repay notes. The most common form pays down the most junior rated class, the Class E turbo, using a stated percentage of the interest that would otherwise go to equity, either after the reinvestment period ends or from a set date.
Some middle-market CLOs and static deals run a senior turbo, applying excess interest to the Class A notes, which deleverages faster and lowers the cost of debt.
A turbo can be scheduled (a fixed percentage every payment date), test-triggered (on a coverage test failure after the reinvestment period, when buying collateral is no longer permitted), or elective (at the manager's option, often to improve OC cushions ahead of a refinancing).
The equity effect differs from diversion: diversion is temporary and rebuilds par, so later distributions can recover; a turbo permanently reduces debt, which lowers the equity's leverage and its expected yield, and is usually structured to end once a target OC level is reached.
A worked example
A CLO has $400 million of collateral par after haircuts and $380 million of rated notes outstanding: ratio 105.3 percent. Junior OC trigger 104.0 percent, interest diversion trigger 105.5 percent.
Loan downgrades push $12 million of the pool over the CCC limit; those loans trade at 70, so the excess CCC haircut removes $3.6 million of par. The ratio falls to 104.3 percent: the OC test still passes, the interest diversion test fails.
On the payment date, $3.0 million of interest is left after the notes and fees. $1.5 million (50 percent) is diverted and buys loans at 92, adding about $1.63 million of par. The equity receives $1.5 million instead of $3.0 million.
If the next quarter adds another $1.63 million of par and the CCC loans recover, the ratio moves back above 105.5 percent and the diversion stops. If instead the loans default, the OC test fails next and the remedy changes from buying loans to repaying notes.
Reading it in trustee reports and fund disclosures
The monthly trustee report lists the interest diversion test with the OC and IC tests: the current percentage, the trigger, the cushion and pass or fail. A cushion under 1 percent is the number to watch.
CLO equity funds report the share of their portfolio's deals that are diverting or failing OC tests. AltStreet's Eagle Point Credit review tracks the fund's NAV per share, which fell from $13.39 at the end of 2021 to $5.70 at the end of 2025, and the rising return-of-capital share of its distributions, which is the fund-level echo of underlying deals paying the equity less.
During the 2020 sell-off, a large share of broadly syndicated loan CLOs tripped their interest diversion tests as CCC buckets rose above their limits; far fewer failed junior OC tests, and most cured within two to three quarters as managers reinvested at discounts. That episode is the test working as designed.
Frequently asked questions
- What is the interest diversion test in a CLO?
- A coverage test measured like the junior OC ratio, collateral par divided by the par of all rated notes, with a trigger set above the junior OC trigger. If the ratio is below the trigger on a payment date during the reinvestment period, part of the interest that would go to the equity is used to buy more loans instead.
- How is the interest diversion test different from the OC test?
- Same ratio, different trigger and different remedy. An OC test failure diverts interest to repay the notes in order of seniority, which deleverages the deal. An interest diversion test failure diverts a portion of the equity's interest to purchase collateral, which rebuilds the asset side without paying down debt. The diversion trigger is set higher, so it trips first.
- How much interest gets diverted?
- Most broadly syndicated loan CLOs divert 50 percent of the interest proceeds remaining after the senior fees, the rated-note interest and the junior management fee, until the test is back in compliance. Some deals divert more, and some allow the manager to cure the test by contributing principal instead.
- What is a turbo in a CLO?
- A turbo feature applies a portion of excess interest to repay notes ahead of schedule, typically the most junior rated class, often called the Class E turbo. It is common in middle-market CLOs and in some deals after the reinvestment period ends. Unlike the interest diversion test, which buys collateral, a turbo reduces leverage.
- Does the interest diversion test apply after the reinvestment period?
- Usually not. After the reinvestment period the manager can no longer buy new loans with diverted cash, so the indenture either switches the test off or converts the same trigger into a note paydown mechanic. Read the definition of the test's applicable period in the indenture.
- Where do I see whether a CLO is failing its interest diversion test?
- In the monthly trustee report, in the coverage tests section, beside the OC and IC tests: the current ratio, the trigger and pass or fail. CLO equity funds such as Eagle Point Credit summarize how many of their positions are diverting or paying down in their quarterly materials.
- Is diversion bad for CLO equity?
- In the quarter it happens, yes: the equity distribution is cut by the diverted amount. Over the life of the deal it is often protective, because buying loans at a discount with diverted interest raises par and can restore the junior OC cushion, which is what keeps the equity's later distributions flowing.