Collateralized Loan Obligations

What is “Collateralized Loan Obligations”?

Collateralized Loan Obligations (CLOs) are a financial tool used to reallocate credit risk in fixed income markets. They are essentially securities that are backed by a pool of loans usually issued by financial institutions (these are often corporate loans with low credit ratings). In essence, CLOs are comprised of bank loans or these are the basic components of a CLO.

In the case of CLOs, certain types of loans are pooled together and transferred to a “Special Purpose Vehicle.” This vehicle then issues debt that is sold to institutional investors. The money raised is used to acquire or fund the purchase of these loans made to companies that are rated below investment grade This essentially means they have acquired a diversified portfolio of a certain type of secured bank loans – known as senior secured bank loans.

CLOs – Returns, Default Risk and Asset Manager

CLOs repackaged loans are typically sold to investors who are seeking the potential for higher than average returns in return for taking on the default risk. With a CLO, investors receive periodic (most often, quarterly or semi-annual) interest income earned on the underlying diversified portfolio of loans. The principal is paid when it is due, i.e. at maturity, and the average length is 10 years.

Asset managers issue and manage CLO’s. They raise capital from investors, among other responsibilities, and use the same to purchase loans through a syndication process.

CLOs – Capital Structure and Tranches

A CLO has a capital structure that can combine several elements with the objective of generating above average returns through income and capital appreciation.

It is important to note that the bulk of a CLOs underlying collateral pool is made up of first lien leveraged loans (i.e. senior secured loans). Further, in addition to senior secured debt, the underlying CLO portfolio might also include a small amount of second lien and unsecured debt.

In the event of bankruptcy, the first lien senior secured loans are the most important with reference to priority of payment in the borrower’s capital structure. This ranks ahead of unsecured debt and represents the least risky investment in these companies. In other words, in the event of bankruptcy, these loans, as senior secured claims, have the earliest claim on all the related company’s assets.

CLOs can also consist of tranches that hold the underlying loans and a portion of equity. In other words, CLOs can issue debt and equity to purchase a diverse portfolio of senior secured loans. The issued debt is sold in separate tranches or classes. Each tranche has a different risk and return profile predicated on its priority of claim on the cash flows from the underlying pool of loans. Institutional investors have the latitude to invest in whichever tranche that fits in with their risk-return profile.

The priority of claims on cash-flow distributions and exposure to loss from the underlying collateral pool is different for each CLO tranche. The cash flow distributions begin with the senior most debt tranche of the CLO Capital Structure and flow down to the bottom equity tranche. This distribution methodology is referred to as “waterfall”. The higher (lower) rated the tranche, the less  (higher) risky is it and lower (higher) is the return.

The highest rated AAA tranche (or the most senior class) has the highest claim on the cash flow distributions, even though it has the lowest yield. The Mezzanine tranches have a lower rating, and pay higher coupons as they are more exposed to loss and are lower in the order of claims on cash flows. The equity tranche, the most junior or lowest tranche, is the riskiest (highest default rate and highest return). Its claim on cash flows is after meeting all the obligations for each debt tranche.

The more senior tranches are exposed only to the loss of principal. However, more junior tranches can be wiped out through defaults on the underlying assets and are the first to suffer losses if borrowers in a CLO default or are unable to honor their debt payments.

In essence, the debt payments that are made on the underlying loans are pooled together. Thereafter, the same is distributed to investors – commencing from the senior most tranche down to the most junior one – with increasing return accompanied by higher risk.

It might be noted that the tranches of a CLO are ranked from the highest to the lowest, in order of credit quality, asset size and stream of income. Consequently, the highest (lowest) tranche is the lowest (highest) with reference to the order of riskiness.

CLOs – Advantages and Risks

Advantages

• On a risk adjusted basis, CLOs tranches have historically given substantially higher returns than other categories of corporate debt
• CLOs can be an effective hedge against inflation
• Compared to other debt instruments, CLO spreads are usually higher
• CLOs can provide the benefit of diversification in a broader portfolio

Risks

• A portfolio of leveraged loans tends to have inherent credit risk, as these are made to companies that are rated below investment grade
• Cash flows to lower tranches can be adversely impacted if a CLO’s loans incur losses or there is collateral deterioration
• Leveraged loan borrowers could choose to prepay their loans either fully or in stages, so the quantum, timing and frequency of prepayments, which are unpredictable, can result in a potential disruption of cash flows and inhibit a CLO manager’s from maximizing portfolio value

Example of a typical Collateralized Loan Obligation

This shows what a typical CLO can look like and the composition of debt within: