Overcollateralisation test (OC test)

Most cashflow CDOs include measures to protect senior note holders in the event of deterioration in the par value of the collateral portfolio. This is known as an overcollateralisation (OC) test or par coverage test.

If a deal starts to fail its OC test, cashflows are diverted from more junior classes of notes to pay down the liabilities in order of seniority until the deal is back in compliance with the test.

The OC test is passed if the overcollateralisation ratio exceeds a predefined level. The OC ratio is the par value of the portfolio collateral divided by the par value of the deal’s liabilities. Therefore, paying down the most senior notes should increase the OC ratio by decreasing the size of the deal’s liabilities.

A deteriorating OC ratio usually indicates a decline in the credit quality of the portfolio. The par value of the portfolio will decline if there are defaults in the portfolio.

In most cashflow CDOs, the downgrade of a portfolio asset to a distressed rating (such as triple C) will also reduce the par value of the portfolio, since in those circumstances, the market value of the asset (or a rating agency recovery assumption) is used in the calculation of the ratio rather than its par value.

The other way that the par value of the portfolio changes is as a result of portfolio substitutions. For example, if an asset is sold for 90% of face value and a new asset is bought with the proceeds at 100%, the aggregate amount of the portfolio in par terms will decrease. Conversely, if an asset trading close to par is swapped for a distressed asset, the par value of the portfolio will increase. Such a substitution is therefore known as a ‘par building’ trade.

Compare interest coverage test.