What Is Collateralized Loan Obligations? How it Works, Pros and Cons

collateralized loan obligations
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collateralized loan obligation (CLO) is a sophisticated financial instrument in which investors receive a small portion of the payments from hundreds of business loans.

In this article, we’re going to keenly define collateralized loan obligations, how it works, and other relevant information.

Before we define collateralized loan obligations, take a quick look at the table of contents below.

What Is Collateralized Loan Obligations?

According to Wikipedia, Collateralized loan obligations are a form of securitization where payments from multiple middle-sized and large business loans are pooled together and passed on to different classes of owners in various tranches. A CLO is a type of collateralized debt obligation.

Investopedia further posits that collateralized loan obligations (CLO) are often approved by corporate loans with low credit ratings or loans taken out of private equity firms to conduct leveraged buyouts.

With a CLO, the investor gets 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.

In few lines, you’ll find out how CLO works.

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How Collateralized Loan Obligation Works

First-lien bank loans to businesses that are ranked below investment grade are initially sold to a CLO manager who gathers various loans together and maintains the consolidation, actively buying and selling loans. To finance the purchase of new debt, the CLO manager sells stakes in the CLO to outside investors in a structure called tranches. Each tranche is a piece of the CLO, and it dictates who gets paid first when the underlying loan payments are made.

It also prescribes the risk associated with the 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 they receive smaller interest payments. Investors who are in later tranches may be paid last, but the interest payments are higher to compensate for the risk.

There are four stages of the CLO life cycle, which occur over eight to 10 years:

  1. Warehousing
  2. Issuance
  3. Expansion
  4. Repayment

Warehousing

This is where the owners of the collateralized loan obligation create a structured investment vehicle. It’s like establishing a company in the business of buying loans. But, to purchase those loans, they first need to raise some capital.

To get started, the CLO takes out a short-term loan from a warehouse provider. This money is used to acquire an initial suite of loans to create a portfolio. This debt is paid off with money raised during the issuance of the CLO.

Issuance

After warehousing, the CLO then looks to investors to finance the endeavor. This is done by selling what are effectively bonds in tranches, with a return on investment proportionate with the risk. Insurance companies, large banks, and pension funds often purchase these securities.

They offer senior-level debt that receives first call on revenues. That financial security would have the least risk and lowest coupon rate. Therefore, it would receive a rating of AAA or AA.

If an investor is looking for a better return and is willing to take a little more risk, they might purchase junior level debt. These securities are subordinate to the senior level debt, meaning they only get paid once the higher level debt is satisfied. These securities might get rated A or BBB.

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An even lower tranche is the mezzanine level. These are typically considered high-risk, but generate high-returns when they are paid. However, all debt investors above mezzanine debt investors have priority in payment. These securities might get rated BB or lower.

The CLO might also sell some equity to raise capital. An equity owner has every right to a portion of the profits the CLO eventually earns. Because all debt investors must be paid before there are any profits to distribute to equity owners, this can be considered the riskiest level of investment in the CLO. Typically, hedge funds and venture capital investors are the ones interested in this option.

Expansion period

With the money raised during issuance, the CLO manager expands the portfolio of leveraged loans. Over a set period, the manager actively manages the loan portfolio. They can sell some loans, buy others, and reinvest revenues received from assets in the collection. During this time, investors might be prohibited from requesting their money back. This period is referred to as a non-call period.

Repayment period

After the reinvestment period is over, the CLO manager cannot purchase or sell any more loans. From that point on, revenues from the hidden assets go toward repaying the debt investors. Revenues are distributed down the capital stack, in order of the priority for each tranche.

The AAA tranche gets paid first — meaning they have the lowest risk exposure and the fastest repayment time. In exchange, they receive the lowest return on their investment. Once the AAA tranche is paid, the AA tranche is next. Revenues are distributed in this way (called a cashflow waterfall) until all the debt investors have been satisfied.

The CLO manager can also sell equity rather than structured debt to generate funds. However, equity is a very risky investment options in the CLO. Of course, it also provides the most potential reward. Equity investors are typically hedge funds, investment banks, and venture capital groups. If there are additional revenues, after paying off all the debt, those revenues are distributed to the owners of the equity tranche. Once all the underlying assets are expired, the CLO is closed.

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Is CLO Actively Managed?

CLO portfolios are actively managed over a fixed tenure known as the “reinvestment period,” during which time the manager of a CLO can buy and sell individual bank loans for the underlying collateral pool in an effort to create trading gains and mitigate losses from deteriorating credits.

What is a CLO security?

A CLO security is a financial instrument that gives the owner a right to payment from the CLO.

The CLO issues these securities in tranches with each level representing a distinct amount of risk and potential gains. An investor can choose to purchase a security at the risk level they are willing to accept.

The most senior tranche is AAA, which pays a lower return on the investment but receives priority on payments. A junior tranche might be rated BB, which offers a higher coupon rate (the amount of interest the investor expects), but comes with the risk that not enough money will be earned to pay off the senior securities and still make the payment on the junior levels.

How Does CLO Make Money?

A collateralized loan obligation (CLO) capitalizes on changing the risk profile of a loan to alter the acceptable interest rate associated with it. This difference in interest rates is called a spread, which allows an opportunity for generating profits.

As long as the weighted-average interest rate paid to CLO investors is lower than the risk-weighted interest being received on the loans in the portfolio, the CLO will earn a profit.

Loans within the CLO typically pay between 200 and 500 basis points above the benchmark interest rate. If the loan is 200 basis points above the London Inter-Bank Offered Rate (LIBOR), and LIBOR is 1.5%, the loan would be 3.5%.

The AAA tranche of the CLO might be set at LIBOR plus 100 basis points and make up 65% of the issuance. The AA tranche might be LIBOR plus 175 basis points and represent another 10%. The lower levels will pay higher rates but come with more risk.

In this way, the CLO can be structured to pay out less on its debt than it receives from the underlying loan assets.

What Are The Pros and Cons of Collateralized Loan Obligations?

Pros of collateralized loan obligations

Because of the high-yielding nature of the underlying leveraged bank loans, even after subtracting the CLO manager portfolio management fees and expenses, the net yield on CLO debt is still attractive to some investors. And due in part to the relative value of CLOs compared to other structured finance securities.

The consistent performance of the underlying bank loans combined with more stringent capital structures makes CLOs an attractive investment opportunity for investors who have not previously participated or perhaps, who have participated only on a limited basis.

Investing in CLOs represent attractive investment options when risk/reward opportunities may be challenging.

Corporate finance institute lists the following as advantages of CLOs.

1. Over-collateralization

The higher-ranking tranches in a CLO are over-collateralized in that even if several loans default, the higher-ranking tranches would not be affected. In the event of loan defaults, the lower tranches are the first to suffer losses.

2. Floating rate loans

The underlying loans of a collateralized loan obligation are floating-rate loans. This results in a low duration. Therefore, collateralized loan obligations are subject to risk from changes in interest rates.

3. Actively managed

CLOs are actively managed and monitored by a loan manager (or loan managers). Although the managers collect management fees, their expertise adds to the performance of the collateralized loan obligation.

4. Hedge against inflation

Due to CLOs consisting of floating-rate loans, they can be used as a hedge against inflation.

5. Higher returns

Over the long term, according to PineBridge, CLO tranches significantly outperformed other corporate debt categories (bank loans, non-investment-grade bonds, investment-grade bonds, etc.).

How Risky Is A CLO?

Cons of Collateralized loan obligations

Several built-in protections help mitigate some investor risk, but every investment comes with uncertainty. However, CLOs have performed well over the last few decades.

As with most investments, CLOs have credit risk. That is, the risk that the underlying portfolio cannot generate sufficient cash flow to pay investors on a full and timely basis when principal or interests are due. This potential payment default can also be influenced by a few factors, one of which is the leveraged bank loan market.

Again, a default in payment on the leveraged bank loans results in less cash for the underlying portfolio and fewer funds available to pay CLO investors. For this reason, it is important that CLO portfolios are diversified by issuer and industry. If the leveraged bank loan market experiences difficulties, the liquidity of CLOs could also be negatively impacted.

Prepayment risk may also arise as interest rates decrease and leveraged bank loan offers to refinance any floating-rate loans, reducing the underlying CLO portfolio principal value.

Another con of CLOs can be found in the inexperience of the CLO manager. When your CLO appears clumsy and inexperienced in the act of credit analysis, portfolio management, and other necessary operations and administrative duties, it affects the performance in the market.

Lastly, maintaining adequate issuer diversification across multiple portfolios is also a potential risk factor worth noting. CLO portfolios have a certain amount of overlap across issuers given leveraged bank loan assets tend to be acquired in the primary market, and a large amount of overlap can occur when demand for bank loans outpaces supply.

Final Thoughts

CLOs purchase risky loans with money received from different groups of investors. The interest and principal payments from the loans are then distributed to CLO investors according to a specific order: senior investors get paid first, junior investors next, and equity investors last.

References

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