A Collateralized Loan Obligation (CLO) is a single security backed by a pool of debt. The process of pooling assets into a marketable security is known as securitization. CLOs are often backed by corporate loans with low credit ratings or loans taken out by private equity firms to conduct leveraged buyouts. A CLO is similar to a Collateralized Mortgage Obligation (CMO), except that the underlying debt is a corporate loan instead of a mortgage.
Key Takeaways
- A Collateralized Loan Obligation (CLO) is a single security backed by a pool of debt.
- CLOs are often corporate loans with low credit ratings or loans taken out by private equity firms to conduct leveraged buyouts.
- With a CLO, the investor receives scheduled debt payments from the underlying loans, assuming most of the risk if borrowers default.
How Collateralized Loan Obligations (CLOs) Work
A CLO is a bundle of loans ranked below investment grade. They are usually first-lien bank loans to businesses that are initially sold to a CLO manager and consolidated into bundles of 150 to 250 loans. To fund the purchase of new debt, the CLO manager sells stakes in the CLO to outside investors in a structure called tranches.
With a CLO, the investor receives scheduled debt payments from the underlying loans, assuming most of the risk in the event that borrowers default. In exchange for taking on the default risk, the investor is offered greater diversity and the potential for higher-than-average returns. A default is when a borrower fails to make payments on a loan or mortgage for an extended period.
Each tranche is a piece of the CLO. The order of the tranches dictates who will be paid out first when the underlying loan payments are made. It also dictates the risk associated with each investment since investors who are paid last have a higher risk of default from the underlying loans. Investors who are paid out first have lower overall risk but receive smaller interest payments as a result. Investors who are in later tranches may be paid last but get higher interest payments to compensate for the increased risk.
A CLO is an actively managed instrument: managers can—and do—buy and sell individual bank loans in the underlying collateral pool to maximize gains and minimize losses. In addition, most of a CLO’s debt is backed by high-quality collateral, making liquidation less likely and making it better equipped to withstand market volatility.
Types of CLO Tranches
There are two types of tranches: debt tranches and equity tranches. Debt tranches, also called mezzanine tranches, are treated like bonds and have credit ratings and coupon payments. These debt tranches come first in terms of repayment, and there is also a pecking order within the debt tranches.
Equity tranches do not have credit ratings and are paid out after all debt tranches. Equity tranches rarely receive a cash flow but do offer ownership in the CLO itself in the event of a sale. Because equity tranche investors usually face higher risks, they often receive higher returns than debt tranche investors.
CLOs offer higher-than-average returns because an investor assumes more risk by buying low-rated debt.
CLO Structure
A CLO consists of several debt tranches, ranked according to the creditworthiness of the underlying loans. The lowest tier is the equity tranche, representing ownership of the underlying collateral.
| Structure of a CLO |
|---|
| AAA Tranche |
| AA Tranche |
| A Tranche |
| BBB Tranche |
| BB Tranche |
| Equity Tranche |
As the CLO enters the repayment phase, investors in higher-ranked tranches are paid first, followed by those in lower tranches. Lower-ranked tranches have higher risk profiles but also higher potential returns. In the lowest tier, the equity tranche, investors receive any additional cash flow after the debt investors are paid.
Equity tranche investors also have a degree of control over the CLO that is not available to debt investors. For example, they have options to refinance the underlying CLO loans or reset the reinvestment period.
CLO Process
Here’s an simplified overview of how CLOs are created:
Step 1: Establish the Capital Structure
The first step to creating a CLO is establishing its capital structure, which means the different levels of debt and equity underlying the security. A typical CLO has several debt tranches and an equity tranche, representing ownership of the underlying collateral.
Step 2: Seek Capital
The next step is to raise capital from investors, which is used to buy loans underlying the security. Each investor will contribute to a different loan tranche, with riskier tranches offering higher returns.
Step 3: Choose Tranches
As investors commit capital, they also choose a tranche that meets their risk and return appetite.
Step 4: Purchase Loans
The CLO manager will use the capital from investors to buy loans. The CLO manager can reinvest loan proceeds to improve the portfolio, either by buying additional collateral or selling poorly-performing loans. At this stage, an underwriter analyzes the loan pool and assesses the creditworthiness of the borrowers, determining the appropriate structure and size of the CLO transaction.
Step 5: Create Special Purpose Vehicle
Often, a special purpose vehicle (SPV) is created to issue the CLO securities. The SPV is usually designed to protect the investors in case of default.
Step 6: Pay Investors
Ultimately, the CLO will begin repaying investors with a spread that has been pre-determined for each tranche at the time of closing. Afterward, holders of the equity tranche can call or refinance the loan tranches. Eventually, the CLO begins to deleverage. As the underlying loans are paid off, the CLO manager will repay investors, starting with the most senior tranche. Any remaining proceeds will go to the equity tranche holders.
Step 7: Termination
The CLO transaction may terminate when all of the securities have been repaid or when the underlying loans have been paid off or sold. At this point, any special purpose vehicles are dissolved, and any remaining assets are distributed to the investors.
Benefits of a CLO
CLOs offer various benefits to investors, including but not limited to:
- Portfolio Diversification: CLOs can provide investors with exposure to a diversified pool of loans made to non-investment grade borrowers, reducing the risk of default associated with any individual loan or borrower.
- Higher Yields: CLOs typically offer higher yields than other fixed-income investments such as government bonds or investment-grade corporate bonds. The loans underlying CLOs are made to non-investment grade borrowers and are, therefore, riskier.
- Credit Enhancement: CLOs are structured with tranches having different levels of credit risks. This credit enhancement can provide additional protection to investors in the senior tranches against losses due to defaults in the underlying loans.
- Stronger Liquidity: CLO securities are typically more liquid than the underlying loans as they can be bought and sold in the secondary market. This can make it easier for investors to manage their portfolios and exit their positions when needed.
- Professional Management: The collateral manager is responsible for managing the loan pool that backs the CLO securities, providing investors with access to professional management and expertise in credit markets.
Risks to Consider
With these benefits, there also come downsides to CLOs, which include but aren’t limited to:
- Higher Credit Risk: CLOs are exposed to credit risk related to the underlying loans. These loans are typically made to non-investment grade borrowers, meaning they are more likely to default. A sudden increase in loan defaults could cause significant losses for investors.
- Residual Liquidity Risk: Although CLO securities are more liquid than underlying loans, they are still subject to liquidity risk. During market stress, it may be difficult to find a buyer for CLO securities, making it challenging for investors to sell their holdings or exit their positions.
- Higher Interest Rate Risk: CLOs are typically structured as fixed-income securities with a set interest rate. If interest rates rise, the value of these securities may decline.
- Prepayment Risk: The underlying loans in CLOs can be prepaid, meaning the borrower pays off the loan earlier than expected. This can negatively affect the returns of CLO investors, especially if they expected a certain level of interest income over a longer period.
- Complexity: CLOs can be complex investments, with multiple tranches, different levels of credit risk, and varying payment structures. This complexity can make it difficult for investors to fully understand the risks and make informed investment decisions.
Risky Asset?
Some argue that a CLO isn’t that risky. Research has shown that from 1994 to 2013, CLOs experienced significantly lower default rates than corporate bonds. Only 0.03% of tranches defaulted from 1994 to 2019. Even so, they are sophisticated investments, usually purchased by large institutional investors.
In other words, companies of scale, such as insurance companies, quickly purchase senior-level debt tranches to ensure low risk and steady cash flow. Mutual funds and ETFs typically purchase junior-level debt tranches with higher risk and higher interest payments. If an individual investor invests in a mutual fund with junior debt tranches, that investor takes on the proportional risk of default.
Conclusion
A Collateralized Loan Obligation (CLO) is a type of security allowing investors to purchase an interest in a diversified portfolio of company loans. The issuing company purchases many corporate loans, packages them, and sells these loans in various tranches, each offering distinct risk-reward characteristics. Understanding CLOs helps investors choose their desired risk level and obtain potentially higher returns.
Related Terms: leveraged buyouts, default risk, tranches, credit derivatives.
References
- Guggenheim Investments. “Understanding Collateralized Loan Obligations (CLOs)”.
- National Association of Insurance Commissioners. “Collateralized Loan Obligations (CLOs) Primer”, Pages 1-6.
- PineBridge. “Seeing Beyond the Complexity: An Introduction to Collateralized Loan Obligations”.
