COLLATERIZED LOAN OBLIGATION CLO: All You Need To Know

It’s not surprising that collateralized loan obligations have become more widely used in the financial markets in recent years. Their mix of above-average yield and potential for gain has been attractive in the past. However, the financial media and certain market participants often misunderstand them since the principles of how they work, the benefits they can provide, and the hazards they carry are shrouded in complexity. Despite this, we think CLOs are promising financial instruments and that learning about them is time well spent. We will look more at the collateralized loan obligation manager, funds, and ETFs in this piece. Enjoy!

Collateralized Loan Obligation Overview

Without access to capital, businesses of any size can’t run, grow, or hire new people. Businesses have a better chance of doing well in a healthy economy where capital is easy to get and interest rates are low.

But compared to big companies, SMBs have a much harder time getting money, so they have to pay more to get it. Some lenders and investors may be hesitant to work with small and medium-sized businesses because they often have a lot of debt and a credit rating that isn’t good enough for investment.

This trend has been worsened by recent banking restrictions that make it harder for banks to lend to middle-market businesses. Therefore, private lenders have stepped in to provide financial assistance to this untapped market.

However, a lender has lending limits. Instead, a collateralized loan obligation (CLO) can be created through the securitization of these loans. This helps restore a bank’s lending capability, which in turn lowers company borrowing costs.

CLOs help business leaders pay for mergers and acquisitions, refinance debt, manage capital structures, and pay for general operations, just like asset-backed securities help people pay for cars and homes.

What Is a Collateralized Loan Obligation?

The term “collateralized loan obligation” refers to a type of security that is backed by a group of loans. To put it another way, a collateralized loan obligation (CLO) is just a repackaged loan that is offered to investors. Similar to a CMO, but with loans rather than mortgages as the underlying securities, loan-backed CMOs offer a safe and liquid way to invest in the credit markets.

An investor in a collateralized loan obligation (CLO) gets regular payments from the loans that make up the CLO and takes on most of the risk if the borrowers don’t pay back their loans. In exchange for the risk of default, the investor gets more options for investments and the chance to make more money than usual. The inability to keep up with mortgage or loan payments over a long period of time constitutes a default.

How Does a Collateralized Loan Obligation Work?

CLOs (collateralized loan obligations) use a number of methods, like interest and capital appreciation, to get high rates of return. In a collateralized loan obligation (CLO), the tranches are ranked from most senior to least senior based on things like credit quality, asset size, and revenue stream, with the least senior tranche carrying the most risk.

Most CLO tranches are rated investment grade even though leveraged loans are speculative grade because of diversification, credit upgrades, and subordination of cash flows.

One of a CLO’s most important functions is distributing interest and principal to investors. The basic idea is that distributions are paid out in order of seniority, beginning with the most senior loan tranche and working their way down to the most junior. After expenses have been covered, the remaining distributions are given to the equity tranche holders.

Collateralized Loan Obligation Manager

CLOs are actively managed by trained credit managers who make decisions about which loans to choose and how to reinvest them, which have a big effect on the overall quality of the portfolio they are based on.

To manage and serve the collateral pool well, the CLO manager needs to be able to both find loans and do in-depth credit analysis, as well as have the right infrastructure in place.

So, for an investor to have faith in the CLO manager’s skills and experience, it is important to do a thorough evaluation. This due diligence is meant to help the investor figure out if the collateralized loan obligation manager can do a good job of evaluating the creditworthiness of the underlying assets and give the investor confidence that the collateralized loan obligation manager is looking out for the investor’s best interests.

What Is the Purpose of a Clo?

The main goal of CLOs is to securitize loans (that are syndicated and/or leveraged) made to corporate or private equity borrowers and give them back to investors in the form of interest-paying bonds called “tranches.”

These CLO pools are sizable, often containing between 150 and 250 individual loans. Equity investors own the managed pool and are affected by the profits and losses of the loans it is made up of, as well as any default risk associated with the debt tranche holders who provide term financing for the pools.

Most CLOs are “arbitrage CLOs,” which aim to collect the difference between (a) payments related to interest and principal on the underlying loans and (b) charges, management fees, and other outlays. Balance sheet CLOs are the second classification of CLOs.

Advantages of Collateralized Loan Obligations

Investing in a collateralized loan obligation has various benefits for the investor:

Inflation protection: Floating-rate loans present in CLOs make them a useful tool for protecting against price increases.
Over-collateralization: In a collateralized loan obligation (CLO), the higher-ranking tranches are over-collateralized, which means they wouldn’t be affected even if a lot of loans went bad. Also, the lower tranches of a loan are the first to lose money if the borrower doesn’t pay back the loan.
Credit with a Variable Interest Rate: A collateralized loan obligation has floating-rate loans as its underlying assets. In practice, this means that the duration will be short. Thus, the risk of interest rate fluctuations affects collateralized loan commitments.
Higher returns: Among the many types of corporate debt, PineBridge found that collateralized loan obligation tranches fared the best over the long term (bank loans, non-investment-grade bonds, investment-grade bonds, etc.).

What Is the Difference Between a Cdo and a Clo?

Even smart investors are skeptical of CLOs because they are hard to understand. This is especially true when the business press talks about them. Because they sound the same, “collateralized debt obligations” (CDOs) and “collateralized loans” are often used the same way. Here are some key distinctions between a CLO and a CDO:

#1. Complexity

Comparatively, CLOs are simpler than CDOs. CDOs typically employ a wide variety of derivatives, including credit default swaps. These extra layers of complexity might make it hard for the average investor to understand how CDOs work. Additionally, these derivatives boost leverage, which in turn raises default probabilities. CLOs, on the other hand, are a group of loans with different levels of risk.

#2. Bank Vulnerability

Banking institutions are less vulnerable to CLOs than to CDOs. An article in The Atlantic estimated that Wells Fargo has $30 billion in CLO exposure. While the absolute value is large, it only represented 1.5% of the bank’s total assets. In addition, AAA-rated CLOs are the norm for the banking sector. A financial tranche has not suffered a loss up to this point.

#3. Credit Default Swaps

Utilizing CDS adds another layer of complexity to CDOs. Companies and businesses use credit default swaps (CDS) to protect against losses from the riskiest tranches. Because of this safety net, CDO investors are willing to put their money into riskier tranches. Before the 2008 financial crisis, CDS was used a lot, but providers at the time couldn’t cover defaults. The stock market and other markets crashed as a result.

However, CLOs rarely use CDS.

#4. Risk

Comparatively, CLOs have a lower level of risk than CDOs. In contrast, senior secured loans are diversified, have less exposure to derivatives and leverage, and are part of the former. However, CDOs are more dangerous than conventional bonds because they employ derivatives and leverage. They also highly specialize in having experience in only one business, like the real estate sector.

CLOs are loans to businesses and corporations, therefore, they have legal entities, issuer ratings, and a lower default risk. In contrast, most collateralized debt obligations (CDOs) are made up of residential mortgages, unsecured credit card debt, personal loans, etc., from individuals. Also, read CDO: Meaning, Process, and What You Should Know.

Collateralized Loan Obligation ETF

Janus Henderson AAA (JAAA), the most popular CLO ETF, launched in late 2020 with $1.2 billion in assets. The ETF only buys AAA-rated CLOs, the safest part of a collateralized loan obligation (CLO), due to the senior tranches’ built-in protection mechanism. According to market price data supplied by Janus, the JAAA has enjoyed an average quarterly return of 1.38% since inception, while 2022 year-to-date estimates place the JAAA at a return of -0.34%.

Janus, inspired by the success of JAAA, started a B to BBB CLO ETF (JBBB) in January 2022. However, JBBB hasn’t done as well as JAAA since it started, even though it has fewer assets ($79MM) than JAAA. Even though the market has been very volatile lately, a number of other CLO ETFs are either waiting for regulatory approval or have already done so.

The market for CLO exchange-traded funds (ETFs) has expanded to include products like the Alternative Access First (AFF) Priority CLO Bond ETF. This ETF manages less than $10 million and has returned 0.51% since inception and -0.64% this year.

How Does a Clo Make Money?

When investors put money into a CLO fund, those funds are used to purchase loans, and the money eventually makes its way back to the investors. That’s how clo make money.

How Does an Equity Tranche Differ From a Debt Tranche?

When selling a CLO, there are typically two types of tranches: debt and equity. Like debentures or corporate bonds, debt tranches, which are also called “mezzanine,” give investors a set schedule of interest and principal payments.

On the other hand, equity tranches do not give investors regular cash flows. Instead, they give investors a stake in the value of the CLO when it is resold. Within each of these types, there could be a wide range of tranches, with the riskier options being the ones with the highest yields.

Who Issues, Manages, and Owns Clos?

Investment managers are responsible for issuing and overseeing CLOs. Nearly two-thirds of the 175 CLO managers who are in charge of investments made after the crisis are from the United States. The other third are from Europe.

Tranche is a unit of ownership in collateralized loan obligations. Insurance companies and banks are the biggest holders of the safest, most senior tranches. This is because insurance companies like to invest in things that make money for them. The equity tranche is the most dangerous, but it also has the highest potential reward and gives investors a say in the company’s direction.

How Does Clos Attempt to Reduce Uncertainty?

CLOs usually have covenants that require the manager to check that the portfolio can make its monthly payments of interest and principal. To avoid misallocating funds due to a decline in collateral, coverage is routinely on the check. Most frequently used are the interest coverage and over-collateralization tests, but there are many others.

If the tests fail, the manager will have to redirect cash flows from the junior debt and equity holders to pay off the senior loan holders.

The CLO structure includes various risk protections, including coverage tests. Limits on collateral concentration, the need to spread out the risk across borrowers, and minimum borrower sizes are a few more.

Conclusion

CLO, which stands for “collateralized loan obligation,” is a type of “structured security” that is backed mainly by a pool of loans to firms that have been used as leverage. A CLO manager is responsible for starting and managing the securitization process, which involves buying loans and bundling them together.

Investors in rating CLO debt tranches receive all principal and interest payments before the equity tranche receives any excess cash flows.

Investors should be aware of the risks of CLOs, such as default and losing all of their money, even though the strategy could have benefits like good performance and a customized risk profile.

In order to put a CLO investment strategy into action, it is often helpful to work with a CLO manager who has a proven track record of sourcing high-quality leveraged loans as well as managing collateral pools and CLO structures.

Collateralized Loan Obligation FAQs

The two most common types of collateral are a mortgage and a car loan. If the borrower doesn’t pay back the loan, the lender could take the house or the car. Most business loans also require collateral.

Invoices Collateral.
Cash Collateral.
Investments Collateral
Real Estate Collateral.
Business Equipment Collateral.
Inventory Collateral.

Some loans, like mortgages, car loans, and secured personal loans, need some kind of collateral. The collateral for each of these loans is something different. A mortgage and a home equity line of credit both use your home as collateral.

In the event of loan default, the lender may seek legal action. If you don’t pay, the court might seize your property or garnish your salary. The lender may report the loan to credit bureaus and use debt collectors to pursue payment if payments are overdue.