Cayman Islands: The MASCOT Feature In US CLOs

Last Updated: 2 October 2019
Article by Pamela Sen-Gupta

In recent months a new feature has appeared in the US CLO market which goes by the acronym of MASCOT. "MASCOT" stands for modifiable and splittable or combinable tranches and they have more than a passing resemblance to a feature called "MACR", which stands for modifiable and combinable Remics (where "Remics" stands for real estate mortgage investment conduits, which are special purpose vehicles that sell mortgage bonds).  The MACR feature was used in instruments called "strips" that the likes of Salomon Brothers and other banks in the 1980s brought to the US treasury and residential and commercial mortgage-backed bond markets. Strips gave investors in the safest senior part of the capital structure the option to exchange their senior notes for a combination of strips that pay only interest or a strip that pays mostly principal with a little interest.

With risky credit markets and investors wanting shorter investment risk horizons, the CLO market has had to innovate and draw on features more prevalent in other markets. The birth of the MASCOT feature affords investors largely in the senior non-deferrable and deferrable tranches of a CLO (the "Senior CLO Notes") the opportunity to split their Senior CLO Notes and exchange them for a combination of interest-only notes ("IO Notes") and principal and interest notes ("P&I Notes"), which are effectively the "MASCOT Notes" which are given different names and identifiers. The MASCOT Notes can be exchanged in whole or in part back into the original Senior CLO Notes, if investors so desire. Investors can manage their risk by opting to hold IO Notes in an economic downturn as they become more valuable when credit markets deteriorate and CLO risk premiums (the yield paid over the benchmark rate) get higher and where CLO risk premiums and credit markets narrow, they can opt to hold P&I Notes as the principal portion of the P&I Notes become more attractive.    

The Senior CLO Notes and MASCOT Notes are secured on the same collateral pool and the ratings of the MASCOT Notes derive from the ratings of the Senior CLO Notes. Other commercial terms such as the level of subordination, maturity and principal balance, all remain the same before and after exchange.

P&I Notes and IO Notes differ in that typically the P&I Notes rather than the IO Notes carry voting rights. Also the principal balance in a P&I Note and the notional of an IO Note gets deferred if they have been exchanged from a senior deferrable tranche, but are not deferred if they have been exchanged from a senior non-deferrable tranche. P&I Notes and IO Notes otherwise amortise in line with each other during the post re-investment period and also get redeemed together, if called by the equity investors of the CLO.   

Proponents of the MASCOT feature claim that that it provides investors with flexibility as they can opt to reconfigure the notes they hold by choosing to exchange Senior CLO Notes for MASCOT Notes or not, in response to market conditions; if they choose to hold MASCOT Notes, they can trade them in the secondary market with the expectation that they may be sold by investors if the MASCOT Notes trade above par during the non-call period. This optionality helps to syndicate new issues, albeit arguably to the same CLO investor base rather than new types of investor; and MASCOT Notes are attractive to investors because they combine flexibility with exposure to short-dated notes with a high yield.

Sceptics of the virtues of the MASCOT feature cite investors being more exposed to losses and point to the early indications that not all is rosy, as reflected in a recent Creditflux article which refers to CLO notes with a MASCOT feature having failed to trade in the secondary market a few days ago and that this was the third time a piece of that tranche was part of a bid list for a bid wanted in competition (BWIC).

It remains to be seen if the MASCOT feature will become commonplace in the US CLO market and if it gets adopted by the European CLO market. As to whether the MASCOT is good or bad for investors, the jury is out.  Only time will tell whether this feature deserves the good name the acronym mimics or whether the more cynical market commentators are right, and the MASCOT is not the lucky charm other more optimistic commentators hope it is.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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