Understanding Collateralized Loan Obligations or CLOs

Companies of all sizes require financing to innovate, operate, expand, and create jobs. When capital is widely available and offered at lower rates, businesses are given greater opportunities to achieve economic success.

Small and medium-sized businesses, though, don’t have the same access to capital as large enterprises, which have far greater access to lower-cost financing. These smaller and mid-sized companies usually have high levels of existing debt and a credit rating below investment grade, scaring off some lenders and investors.

Recent banking regulations have only exacerbated this dynamic, making it increasingly more difficult for banks to lend to middle-market companies. As a result, private lenders have filled this gap by extending loans to this underserved market.

A lender, however, cannot endlessly lend capital. Instead, these loans can be securitized and packaged into a collateralized loan obligation (“CLO”). This process helps replenish a lender’s capacity to extend loans to businesses, making credit more available and affordable.

Like asset-backed securities that help families finance automobiles and homes, CLOs help business leaders finance mergers and acquisitions, refinance existing debt, manage their capital structure, or fund general operations.

From Loans to CLOs

Source: Structured Finance Association, February 2020. “CLOs”

A CLO is a security that exposes an investor to a diversified portfolio of company loans. CLO bonds are directly repaid from interest and principal paid on the underlying collateral, and thus the holders of CLO securities must rely solely on distributions from the CLO and do not have direct claims on the underlying assets.

The CLO is created and managed by a CLO manager. The CLO manager is responsible for purchasing loans and packaging them to meet an intended investment strategy via a process called securitization. The manager then prices the security and markets and syndicates it to investors.

Once the CLO is sold to capital market investors, the manager has a few more months to finalize the pool of assets before the reinvestment period begins.

During the reinvestment period (typically a two-to five-year period), any principal payments received are either reinvested into new loans or used to cover any interest shortfall. Conversely, during the amortization period, principal payments are used to pay down note principal (i.e., the principal left on the bonds) sequentially.

CLO Lifecycle

Source: Structured Finance Association, February 2020. “CLOs”

CLO Manager

CLOs are actively managed by professional credit managers whose loan selection and reinvestment decisions have a material impact on the quality of the underlying portfolio.

The CLO manager must have the ability to source loans and conduct thorough credit analysis, while having the required infrastructure in place to effectively manage and service the collateral pool.

Therefore, a thorough assessment is essential for an investor to feel confident in the abilities and expertise of the CLO manager. This due diligence is designed to assist the investor in determining whether the CLO manager can effectively conduct a credit assessment of the underlying assets, as well as provide confidence that the CLO manager is acting in the best interests of the investors.

CLO Structure

Source: Federal Reserve, September 2019. “CLOs in the Financial Accounts of the United States”

Tranches

To fund the loans (collateral), the CLO manager sells stakes in the CLO to investors in a structure called tranches. There are two types of tranches in a CLO, the debt tranche, and the equity tranche.

CLO Tranches

Source: CFI. CLOs (CLO) – “Overview, Creation, Advantages”

Investors in the rated CLO debt tranches receive principal and interest payments, and investors in the equity tranche receive any residual cash flows after all principal and interest payments to the debt tranches are paid. This priority of payments is called the payment waterfall.

Debt Tranche

The debt tranche is treated just like any other bond with credit ratings and rights to contractual coupon payments. The debt payments are distributed to CLO security holders in accordance with the specific tranche owned by the investor, with the senior-most bond being paid first, followed by the mezzanine and the most junior notes.

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 later, but the interest payments are higher to compensate for the risk.

Equity Tranche

The equity piece, which is not rated, sits below all the debt bonds and is only paid to the extent that the structure has excess cash once the management fees, debt coupons, and subordinated fees are paid.

Moreover, the CLO equity tranche, which occupies a first-loss position, is typically in the form of residual interest, such as subordinated notes, income notes, common stock, or preference shares issued by the relevant CLO issuer.

To the extent that any reduction in payments on debt securities occurs, such elimination will be borne first by the CLO junior interests and then by the debt securities in reverse order of seniority.

The strength of the collateral backing the loans is typically one of the drivers of CLO performance. Generally, leveraged loans are floating-rate term debt instruments that are primarily employed by non-investment grade business borrowers.

The cost of issuing unsecured bonds may be prohibitive for some businesses and leveraged loans provide these corporate buyers with important access to institutional financing.

To compensate investors for higher perceived credit or default risk, leveraged loans can offer yields that are considerably higher than investment-grade debt and are backed or secured by an issuer’s assets.

Leveraged loans are repaid before senior unsecured bonds, subordinated bonds, and equity in the event of bankruptcy since loans are often the senior-most position in a company's capital structure. Generally, this has resulted in greater recovery rates than subordinated debt instruments, though actual recovery rates will vary based on the issuer, industry, and macroeconomic circumstances.

For the lender's protection, leveraged loans have covenants in the contract that require the company to follow certain rules, such as providing audited financial statements or refraining from taking certain actions that could jeopardize the company's ability to repay existing debt.

There are many types of CLO owners, including banks, institutional asset managers, pension funds and endowments, insurance companies, and structured credit funds. With interest payments flowing to bondholders sequentially from highest to lowest rated, investors with different risk appetites can target their desired level of risk and return.

Asset owners such as banks and insurance companies are subject to strict liquidity constraints and higher levels of regulatory scrutiny and thus are more inclined to invest in senior tranches, which offer lower levels of return but are less risky and typically more liquid.

For a bond to attain a triple-A rating, it should be able to withstand an extreme level of stress without going into default, while even just a mild level of stress could result in default for a single-B-rated tranche.

Conversely, private equity and private credit funds tend to be more opportunistic and are more apt to invest in the riskier junior debt tranche and the equity tranche. This risk can be attractive to investors who are willing to take on a certain degree of risk but are enticed primarily by the attractive yields often provided by the subordinate positions of a CLO.

CLO Investors

Source: Structured Finance Association, February 2020. “CLOs”

While there are many benefits to CLOs including attractive performance and targeted risk profile, credit enhancements like over-collateralization and subordination, wider yield spreads, low interest-rate sensitivity, and lower default rates, there are several risks that investors should consider carefully.

CLOs have historically enjoyed strong credit quality due to the senior secured status of leverage loans. However, it is important to remember that leveraged loans are issued to companies with a below investment grade credit rating and may be subject to significant credit risk.

Typically, leveraged loans have full recourse to the borrower and its assets in the event of default. However, a CLO has recourse only to the principal and interest payments of the loans in the portfolio. Thus, if the collateral pool fails to meet all contractual commitments, the equity tranche's value could be eliminated, and the junior loan tranches' principal could be reduced as well.

CLO investors are also subject to prepayment risk, or the premature return of principal on a fixed-income security, as borrowers may choose to repay their loans, and the size, timing, and frequency of these payments can potentially disrupt cash flows and challenge managers’ ability to maximize portfolio value.

Lastly, the performance of CLO managers encompasses a wide range of returns, underscoring the importance of choosing experienced managers with long-term track records. There is no assurance that any CLO strategy will create any return for investors, and there is always a risk of default and total loss of investment.

CLOs are investment vehicles or structured securities backed primarily by pools of leveraged loans to businesses. The CLO is created and managed by a CLO manager who is responsible for purchasing loans and packaging them together via a process called securitization.

Investors in the rated CLO debt tranches receive principal and interest payments, and investors in the equity tranche receive any residual cash flows after all principal and interest payments to the debt tranches are paid.

Although there are potential benefits to CLOs, including attractive performance and targeted risk profile, investors must be conscious of the risks inherent to the strategy, including default and total loss of capital.

While there is no assurance of future outcomes, partnering with an experienced CLO manager who has a track record of sourcing high-quality leveraged loans and managing collateral pools and CLO structures can be a critical component in executing a CLO investment strategy.

Sources:
Structured Finance Association, February 2020. “CLOs”
Federal Reserve, September 2019. “CLOs in the Financial Accounts of the United States”
Investopedia, March 2022. “CLO”
NAIC’s Capital Markets Bureau. “Collateral Loan Obligations”
CFI. CLOs (CLO) – “Overview, Creation, Advantages”
PineBridge Investments, March 2022. “CLOs (CLOs): Benefits and Risks”