Weighted Average Spread (WAS)
Definition
Weighted Average Spread measures the portfolio-wide average interest rate spread above the base rate (SOFR/LIBOR), weighted by each loan's par amount. Calculated as sum of (loan par × spread) / total par. A portfolio with $400M at L+400 and $100M at L+500 has WAS = ($400M × 400 bps + $100M × 500 bps) / $500M = 420 bps. WAS directly drives interest coverage tests and excess spread generation—higher WAS creates greater cushion for debt service while lower WAS pressures coverage. CLO managers optimize WAS through credit selection, balancing spread capture against default risk. Typical broadly syndicated loan CLOs target 375-425 bps WAS; middle-market CLOs target 500-650 bps WAS given smaller, riskier underlying borrowers.
Why it matters
WAS determines CLO economic viability and equity return potential. A 25 bps decline in WAS (from 425 to 400 bps) reduces annual interest income by $1.25M on $500M portfolio—material impact on coverage tests that might be running 105-110% (thin cushions). During 2020-2021 spread compression, WAS fell from 450 bps to 375 bps as new issue loans priced aggressively tight. Existing CLOs saw portfolios roll into lower-spread loans during reinvestment period, compressing coverage tests and forcing managers to trade up in credit risk (buying B3 vs Ba3) to maintain WAS—increasing default exposure to preserve coverage. This spread-chasing dynamic explains cyclical credit deterioration: managers accept higher default risk when spreads compress to preserve fee income and avoid coverage test failures.
Common misconceptions
- •WAS doesn't equal expected return—it measures income but ignores defaults, trading gains/losses, and equity distribution timing. High WAS with high default rates destroys value.
- •Minimum WAS covenants rarely bind in practice—they're set so low (300-350 bps) that reaching them requires catastrophic spread compression. Real constraint is maintaining adequate coverage test cushions.
- •WAS compression doesn't necessarily signal lower credit quality. It often reflects technical supply/demand (heavy CLO issuance bidding up loan prices) rather than fundamental improvement.
Technical details
WAS calculation and components
Basic formula: WAS = Σ(Loan Par × Loan Spread) / Total Par. Example: Loan A $100M at L+450, Loan B $150M at L+400, Loan C $250M at L+375. WAS = ($100M×450 + $150M×400 + $250M×375) / $500M = 400 bps.
Floor inclusion: Loans with SOFR floors (minimum base rate regardless of actual SOFR) effectively have higher all-in spreads when floors are 'in the money.' If SOFR = 2.5% and floor = 3.0%, loan at L+400 effectively yields 7.5% (L+500 equivalent). WAS calculations should reflect floor benefit when applicable.
Fees and PIK exclusion: WAS includes contractual spread only—excludes upfront fees (OID), exit fees, PIK interest, and amendment fees. These incremental yields improve actual returns but don't count toward WAS for coverage test purposes. CLOs earning 50-100 bps additional fee income have better economics than WAS suggests.
Current pay vs deferred: Only current-pay cash interest counts toward WAS. PIK toggle loans that defer interest don't contribute to WAS during PIK elections—reducing effective portfolio WAS. This creates coverage test pressure if multiple issuers elect PIK simultaneously (typically during stress).
WAS interaction with coverage tests
Interest Coverage (IC) relationship: IC Test = Interest Income / Debt Service. Higher WAS directly increases numerator (interest income) without changing denominator. A 25 bps WAS increase on $500M portfolio adds $1.25M annual income, improving IC test by 2-3 percentage points depending on structure.
Overcollateralization (OC) impact: While WAS doesn't directly affect OC test (par-based calculation), it influences whether IC test failure triggers cash diversion. Failed IC diverts cash to senior notes, preventing equity distributions. WAS management essential to avoid IC failures even when OC passes.
Minimum WAS covenants: Most deals require WAS ≥ 325-375 bps to maintain ratings. Rarely binding but creates absolute floor. Some deals have WAS step-downs (450 bps years 1-2, 425 bps years 3-5, 400 bps thereafter) reflecting expected spread compression as portfolio seasons.
Coverage test cushion sensitivity: Deal with 107% IC test pass (7% cushion) needs $3.5M income cushion on $500M portfolio. Losing 50 bps WAS ($2.5M income) reduces cushion to 5%—materially increasing probability of future IC failure if additional loans default or migrate to non-accrual.
Market dynamics and cyclical behavior
Spread compression cycles (2017-2021): Heavy CLO issuance ($120B+ annually) created loan demand exceeding supply. Average WAS fell from 425 bps (2017) to 365 bps (2021) as managers bid aggressively for limited loan supply. New issue deals required lower minimum WAS covenants to achieve feasibility.
Spread widening periods (2008-2009, 2020): Market dislocations caused spreads to spike—secondary loans traded L+800-1000 (vs L+400 new issue). Existing CLOs saw WAS increase as portfolios marked to market and trading gains rolled into higher-spread replacements. Coverage tests improved dramatically despite defaults increasing.
Manager incentive conflicts: Management fees (typically 40-50 bps) calculated on collateral par, not equity value. Managers have incentive to maximize WAS through credit risk (preserving coverage tests) rather than optimizing risk-adjusted returns. This creates risk-shifting from equity to manager fee protection.
Competitive dynamics: Top-tier managers command premium spreads (lower WAS) given brand recognition and lower perceived default risk. Second-tier managers accept higher WAS (riskier credits) to generate competitive returns. WAS differential of 50-75 bps between top and second-tier portfolios common.
Trading strategies and WAS management
Defensive trading: During spread compression, managers protect WAS by trading out of tightest loans (L+300-350) into wider credits (L+450-500). This increases portfolio credit risk but maintains income—necessary to avoid coverage test failures that would halt equity distributions.
Credit selection trade-offs: Manager choosing between Ba2 at L+375 vs B2 at L+475 faces fundamental trade-off. Ba2 has 2% default probability vs 4% for B2, but B2 adds 100 bps to WAS. Optimal choice depends on current WAS cushion—if coverage tests tight, manager pressured toward B2 despite higher default risk.
New issue vs secondary: New issue loans typically price 25-50 bps tighter than secondary during normal markets. Managers building portfolios face tension between new issue relationships (necessary for allocation access) and secondary opportunities that boost WAS. Reinvestment period portfolios show higher secondary allocation.
Refinancing risk: When borrowers refinance loans at tighter spreads (L+450 refinances to L+350), CLOs lose 100 bps WAS on that position. Heavy refi activity (2020-2021) caused WAS degradation averaging 50-75 bps across outstanding CLOs—major driver of coverage test compression requiring increased trading velocity.