Overcollateralization (OC) Tests
Definition
A covenant in CLOs and other structured credit products that measures whether the value of the underlying collateral pool exceeds the par value of the debt tranches by a required percentage. OC tests protect senior tranches by triggering cash flow diversion if collateral coverage deteriorates.
Why it matters
OC tests are the primary protection mechanism for senior CLO tranches. When an OC test fails, cash that would otherwise flow to equity holders is diverted to pay down senior debt, restoring the cushion. This explains why AAA CLO tranches rarely experience credit losses even when portfolio credit quality deteriorates—the structure protects them automatically through forced deleveraging.
Common misconceptions
- •OC test failures do NOT mean default. They trigger cash flow diversion, not acceleration or event of default. The structure continues operating normally, but equity distributions cease until the test is cured.
- •OC tests protect against credit deterioration, not liquidity stress. In March 2020, CLO tranches traded at steep discounts while OC tests remained in compliance because the tests measure credit quality (par value), not market prices.
- •Passing OC tests doesn't mean equity gets paid. Interest coverage (IC) tests must also pass, and other structural features (CCC limits, manager discretion) may independently divert cash even when both OC and IC tests pass.
- •OC ratios don't move in lockstep with market prices. A loan trading at 85 cents still counts at 100 cents in OC calculations if it remains performing and rated. This insulates the structure from temporary market volatility but creates lag in recognizing credit deterioration.
Technical details
Calculation methodology
OC ratio = adjusted collateral par ÷ tranche par. CLOs intentionally use par value rather than market value, making OC tests insensitive to mark-to-market volatility but vulnerable to gradual credit deterioration. The 'adjusted' par value applies haircuts for defaulted loans (often marked down materially—sometimes to market value and/or a conservative recovery assumption depending on indenture language), CCC-rated credits beyond bucket limits (often 50-100% haircut), and defaulted interest (excluded from collateral value). Some structures also apply modest haircuts to Caa-rated credits or loans more than 60 days past due. Exact treatment of each credit event is indenture-specific and varies by deal.
Typical thresholds by tranche
AAA tranches typically require 120-135% OC (e.g., $125 million collateral par supporting $100 million AAA tranche par). AA tranches require 110-115%. A tranches 105-108%. BBB tranches 102-105%. Lower-rated tranches have progressively lower requirements, with BB often around 100% and equity having no OC protection. These thresholds vary significantly by vintage (2005-2007 CLOs often had looser tests; post-crisis CLOs tightened), manager track record (experienced managers may negotiate tighter cushions), and market conditions (spread compression leads to tighter structures). Exact triggers are deal-specific; verify in the trustee report or indenture.
Cash flow diversion mechanics
If an OC test fails (e.g., AAA OC drops to 123% when threshold is 125%), cash flows that would otherwise be available for reinvestment or equity distribution are redirected (often via principal proceeds and/or interest proceeds depending on the deal) to pay down the AAA tranche until the OC ratio returns above 125%. This creates forced deleveraging. For example: CLO generates $2 million in principal proceeds. Normally, during reinvestment period, this would buy new loans. With OC failure, it pays down AAA debt instead. If AAA tranche is $100M at 123% coverage, paying down $2M increases coverage to 125.5%, potentially curing the test. The diversion continues monthly until the test is cured or the tranche is fully paid. Equity distributions resume only after both OC and IC tests pass. Important note: Diversion source and priority (interest vs principal proceeds) is indenture-specific and differs between reinvestment and post-reinvestment periods.
Why par value, not market value
Using par value rather than market value insulates the structure from temporary market volatility and prevents forced selling into dislocated markets. During March 2020, broadly syndicated loan (BSL) prices fell 20-30% in weeks. If a performing BB-rated loan fell from par to 75 cents but remained current on payments, it still counted at 100 cents (full par) in OC calculations. This prevented a doom loop: OC test failure → forced asset sales → depressed prices → worse OC → more forced sales. The trade-off: OC tests lag actual credit deterioration. Tests only reflect problems when loans actually default (triggering haircuts per indenture methodology) or are downgraded to CCC (triggering bucket limits and haircuts). A loan can deteriorate from B to B- to CCC+ over 12 months before materially impacting OC, by which time recovery value may be significantly impaired.
Interaction with CCC buckets
Most CLOs limit CCC-rated exposure to 7.5% of collateral par. Loans exceeding this bucket receive 0-50% haircut in OC calculations (structure-dependent). Example: $500M CLO with $40M CCC exposure. Bucket allows $37.5M (7.5%). Excess $2.5M gets 50% haircut, reducing collateral value by $1.25M in OC calc. This creates a 'cliff' where small rating downgrades (from B- to CCC+) can trigger large OC impacts if the portfolio is already at bucket limits. Managers actively trade out of deteriorating credits before they hit CCC to preserve OC ratios.
OC test frequency and cure mechanisms
OC tests are measured monthly or quarterly (depending on structure) using the most recent trustee calculation. Tests can be cured through: (1) Deleveraging – paying down the tranche with diverted cash until ratio improves, (2) Portfolio improvement – trading deteriorated loans for higher-quality credits (if manager has discretion and cash available), (3) Defaults working through – if defaulted loans recover more than assumed in initial haircut, recovered proceeds improve the ratio, or (4) Rating upgrades – loans moving from CCC back to B restore full par value. Most cure through deleveraging over 6-18 months. Rarely, OC tests remain failed for years if credit environment deteriorates broadly (2008-2009 vintage CLOs).