Collateralized Loan Obligations (CLO)

Collateralized loan obligations (CLOs) are loans that are repackaged and bought by investors. These securities are backed by a pool of loans comparable to collateralized mortgage obligations (CMOs). With CLOs, the underlying debt is loans, as opposed to mortgages.

Securitization is the process of pooling assets into a marketable security. CLOs are often used by private equity firms to carry out leveraged buyouts (LBOs) and are backed by corporate loans with low credit ratings.

Investors take on most of the risk if borrowers default and cannot make regular debt payments on the underlying loans. Since investors have to take on default risk, they are provided with diversification and higher-than-average projected returns.

Because of their above-average yield, collateralized loan obligations have become prominent in recent years.

CLOs were created in the late 1980s as a way for investors to receive leverage loans that had varying degrees of risk and return. This allowed investors to reach their investment goals more quickly.

Understanding collateralized loan obligations

Investors receive debt payments from underlying loans that are pooled together. The debt payments are distributed to investors of different tranches in a CLO.

Tranches are portions of a pooled collection of debt instruments. The instruments are divided by risk and other features that may make them attractive to confident investors. For example, loans may be differentiated by their maturity or rate of return.

Investors can decide what tranches they want to invest in based on their risk/return profile. Less risky tranches have lower returns and higher credit ratings. Equity tranches are the lowest-rated ones with the highest default risk and the highest return.

The underlying loans that comprise a CLO are mostly made up of first-lien senior-secured bank loans. A first-lien loan has a first claim on a debt's collateral, and a senior-secured loan also has priority repayment status in the event of bankruptcy.

Second-lien loans and unsecured debt can also be found in CLOs. Borrowers make debt payments on the underlying loans, starting with the highest-rated tranches with the lowest risk and return.

Bottom tranches are the riskiest but offer the highest return. Thus, investors at the bottom of the tranche must take on the highest risk. If borrowers default and cannot make their debt payments, investors at the bottom tranche would be the last to receive money and, effectively, the first to bear the loss.

A CLO has two different types of tranches: debt and equity tranches. Debt tranches, also referred to as mezzanine tranches, operate like bonds. They have credit ratings and coupon payments.

On the other hand, equity tranches do not have credit ratings and are subordinated to debt tranches. In the event of a sale, equity tranches provide ownership. However, they are not often paid a cash flow. 

Forming a collateralized loan obligation

The goal of a CLO is to generate above-average returns through income and capital appreciation.

A CLO manager buys loans below investment grade (typically first-lien bank loans to businesses). The manager then combines the loans and oversees the combinations by buying and selling loans.

The manager sells stakes in the CLO to finance the purchase of new debt. The stakes are sold to outside investors in tranches.

To summarize, the steps for creating a collateralized loan obligation include the following.

There are typically five stages of the standard lifecycle:

1. Warehousing: Before the closing date, the manager buys the initial collateral. 
2. Ramp-up: After the closing date, the manager buys the leftover collateral to finish the original portfolio. Following the ramp-up stage, the manager carries out monthly tests to make sure the portfolio can make its interest and principal payments. 
3. Reinvestment: After the ramp-up phase, the manager may reinvest all of the loan proceeds by either buying or selling bank loans in order to enhance the credit quality of the portfolio. 
4. Non-call: Loan-tranche holders receive a per-tranche return at closing. Then, the majority of equity-tranche holders can either call or refinance the loan tranches. 
5. Repayment and deleveraging: While underlying loans are being paid off, the manager pays down loan tranches based on seniority and allocates the leftover proceeds to the holders of equity tranches. 

Advantages of collateralized loan obligations

For investors looking to broaden their horizons concerning yield, collateralized loan obligations have been gaining increasing attention.

Many investors understand that collateralized loan obligations have performed attractively over other fixed-income investment strategies. However, they may not be aware of all the benefits and advantages.

Advantages of investing in a collateralized loan obligation include the following:

1. Over-collateralization: The tranches of a CLO that are ranked higher are over-collateralized. This means that, in the event of a loan default, these tranches would not be impacted. Usually, lower-ranked tranches face losses in the event of loan default. 
2. Floating-rate loans: The underlying loans that make up a CLO are floating-rate loans. The result of this is low duration, meaning that they are at risk from changes in interest rates. 
3. Actively regulated: Loan managers actively regulate and monitor CLOs. Managers charge fees, but they are usually based on performance. 
4. Dodge inflation: Because CLOs have floating-rate loans, they can be used as a way to hedge against inflation. 
5. High returns: CLO tranches substantially surpass other corporate debt categories (e.g., bank loans) over the long term in terms of returns. 
6. Wide yield spreads: Usually, CLOs have wider spreads than other debt instruments. As a result, they are more complex and have fewer liquidity and regulatory obligations. 

Risks of collateralized loan obligations

One of the goals of a collateralized loan obligation is to mitigate potential risk through its multi-level structure.

Nevertheless, a CLO's complexity accompanies several risks that investors must consider. Here are a few important risks to consider:

• Issuance timing: Market conditions may not be strong during a CLO's reinvestment period, even if they were strong at the time of issuance. Poor market conditions during the reinvestment period can lead to a decrease in trading volume. 
• Manager selection: It is extremely important to select an experienced CLO manager with a strong track record over the long term. 
• Duration of spread: Because CLO tranches have floating rates, the interest rate duration is low. However, it is still important to consider the spread duration of a CLO. Spread duration is typically between 3.5 and 7 years because the usual reinvestment period is four to five years.

If there is a higher capital stack, there is a lower spread duration because each CLO is successively redeemed. This causes the lower-rated tranches to have a longer spread duration.

Researched and authored by Rachel Kim | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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