The IC test is the overcollateralisation test's quieter twin. It rarely trips first, and rising rates push it down even when no loan has defaulted.
The interest coverage ratio is the interest the collateral pays, less senior expenses, divided by the interest due on the tested class and every class senior to it. On an illustrative 1,000 CRE CLO with 800 of notes, the Class D ratio is 75.00 / 48.87 = 153.5 per cent, against a 120 per cent trigger. It trips only when 212.4 of loans stop paying interest, far later than the overcollateralisation test, but it falls steadily as SOFR rises, even with no defaults at all.
Worked in full in CMBS and CRE CLOs by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A fictional managed CRE CLO of transitional floating-rate loans. Loans and notes both float on SOFR. Senior expenses are trustee, administration and other fees paid ahead of the notes. All figures are illustrative.
| Item | Balance | Spread over SOFR |
|---|---|---|
| Loan pool | 1,000.0 | 3.40% |
| Class A | 500.0 | 1.40% |
| Class A-S | 100.0 | 1.80% |
| Class B | 70.0 | 2.20% |
| Class C | 60.0 | 2.80% |
| Class D | 70.0 | 3.50% |
| Preferred shares (equity) | 200.0 | residual |
SOFR 4.30 per cent, senior expenses 0.20 per cent of the pool, IC trigger 120 per cent.
Interest collections = 1,000.0 × (4.30% + 3.40%) = 1,000.0 × 7.70% = 77.00
Less senior expenses = 1,000.0 × 0.20% = 2.00
Available for the notes = 75.00
IC ratio for class X = available interest / interest due on class X and all classes senior to it
Excel: =Available/SUM(Due_A:Due_X)
| Class | Coupon | Interest due | Cumulative due | IC ratio |
|---|---|---|---|---|
| A | 5.70% | 28.50 | 28.50 | 263.2% |
| A-S | 6.10% | 6.10 | 34.60 | 216.8% |
| B | 6.50% | 4.55 | 39.15 | 191.6% |
| C | 7.10% | 4.26 | 43.41 | 172.8% |
| D | 7.80% | 5.46 | 48.87 | 153.5% |
After all five classes, 26.13 of interest is left for the equity: that excess spread is what the IC test protects the notes from losing, and what the equity loses first when it fails. Many CRE CLOs test coverage at a single level near the bottom of the note stack; others test several classes. The tested level and the trigger are set in each indenture.
A loan that stops paying interest drops out of the numerator but not the denominator. Solving for the non-accruing balance that takes the Class D ratio to 120 per cent:
(1,000.0 − X) × 7.70% − 2.00 = 1.20 × 48.87, so X = 212.4, or 21.2 per cent of the pool
The Class C test, with less interest due, needs 297.5.
Compare the overcollateralisation test on a deal of the same size: with 800 of notes and a 122 per cent trigger it trips at 60.0 of defaults, as worked in how the overcollateralisation test is calculated. Because the pool earns a wide spread over the notes and the equity is 20 per cent of the deal, the IC test has more than three times the room. In most CRE CLO stresses the OC test diverts cash long before the IC test notices. At 150 of non-accrual, the Class D IC ratio is still 129.8 per cent.
| SOFR | IC ratio | Non-accrual to hit 120% |
|---|---|---|
| 2.00% | 170.7% | 285.9 |
| 3.00% | 161.2% | 247.4 |
| 4.30% | 153.5% | 212.4 |
| 5.50% | 148.8% | 189.2 |
| 7.00% | 144.7% | 167.7 |
Higher rates lower the ratio without a single default. Both sides earn SOFR, but the numerator earns it on 1,000.0 and the denominator pays it on 800.0, so as SOFR rises the ratio converges on 1,000.0 / 800.0 = 125.0 per cent, ever closer to the trigger. At the same time higher rates strain the borrowers' own coverage, so the room to the trigger shrinks just as non-accrual becomes more likely. Loan modifications work the same way: cutting the spread on 300 of loans to SOFR plus 1.00 per cent, a common concession in an extension, takes the Class D ratio to 138.7 per cent with every loan still paying.
When the test fails, the cure is mechanical: interest that would have gone further down the waterfall is applied to repay the most senior notes until the ratio is back above the trigger. Repaying Class A reduces interest due at every level, so each unit of diversion lifts the ratio, but the cost falls on the equity and the junior classes, whose cash flow stops while the deal deleverages. A manager watching the IC ratio therefore watches the equity distribution, not the safety of Class A.
Treating a comfortable IC ratio as a sign of credit health. The IC test counts cash interest, so it ignores loans that are modified to pay part of their interest in kind, loans kept current by an interest reserve, and loans whose sponsors are funding shortfalls out of pocket. A deal can show 150 per cent coverage while its collateral is quietly deteriorating; the OC test, the loan-level debt yield and the watchlist tell the rest. The second mistake is testing coverage on the most senior class only: Class A at 263.2 per cent says nothing about whether the equity will be paid next quarter. For the equity's own return before and after losses, see how to calculate the equity return on a CRE CLO.
The book's CRE CLO model, with the advance rate, the break-even loss rate and the overcollateralisation test live, is in the free workbook for this case.
The OC test compares collateral principal, with defaulted loans haircut, to the notes outstanding; the IC test compares interest collected to interest due. In the illustrative 1,000 deal with 800 of notes, the OC test trips at 60.0 of defaults while the Class D IC test needs 212.4 of loans on non-accrual, so the OC test is normally the one that diverts cash first.
Because the loans and the notes both float on SOFR, but there is more collateral than notes. As SOFR rises, both sides grow by SOFR times their balance and the ratio converges on pool over notes, 125.0 per cent here. The illustrative Class D ratio falls from 170.7 per cent at a 2.00 per cent SOFR to 144.7 per cent at 7.00.
Interest that would have flowed to the junior notes and the equity is diverted to pay down the most senior notes until the ratio is restored. The equity's cash flow stops first. Each deal's indenture sets the trigger, the class at which the test is measured and the order of the diversion.
This article is one calculation from CMBS and CRE CLOs. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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