Introduction to CLOs

January 26, 20224 min read
Introduction to CLOs
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Collateralized Loan Obligations, or CLOs, are structured credit investment vehicles that can offer investors a more efficient means of managing their risk and return targets for fixed income investments. One of the benefits of CLOs is that they allow investors to choose an investment that suits their risk profile, with return targets commensurate with their risk preference.  Investors are generally paid a floating rate of interest that resets at regular intervals. CLOs have been available for over 30 years, and are popular investments among banks, institutional asset managers, hedge funds, and high net worth individuals.

A CLO can be thought of as a securitized investment fund. The CLO has an investment manager who buys and sells loans on behalf of investors in the fund. CLOs generally invest in leveraged loans to companies that look to borrow significant sums of money to fund their growth, research, or independence. 

How do CLOs work?

The unique features of CLOs are that they simultaneously take advantage of diversification (CLOs generally invest in the debt of 100 companies or more), and at the same time satisfy the risk appetite of a diverse array of investors. CLOs pool loans which can  create well-diversified portfolios. Each loan has its own characteristics; some loans may be of higher quality and lower risk, while other loans may be made to relatively new companies with novel products without an established track record. The CLO is “tranched,” or divided, often into three classes: senior, mezzanine, and equity. The senior and mezzanine tranches are structured as interest-paying bonds, while investors in the equity tranche receive income generated by the CLO following interest payments to senior and mezzanine holders and then also have the potential to benefit from capital appreciation at the time the CLO is sold..

Those three classes of investments compensate investors according to the risk they undertake. If the CLO has 100 loans, it will receive 100 interest payments, and those payments will be paid in descending order to senior, mezzanine, and equity investors. Since senior investors are paid prior to other investors, they take less risk and accept a lower rate of interest. Mezzanine investors undergo moderate risk and receive an interest rate higher than senior investors, while equity investors, who accept the highest risk of the three classes, receive all residual payments, similar to investors in common shares of listed corporations.

According to Standard and Poor’s, the bond rating agency, leveraged loans are senior secured bank loans with a rating of BB+ or lower. The loans are secured by a first or second lien. Because the underlying leveraged loans are generally liquid and trade on a secondary market, the manager of the CLO can actively manage the loans in the portfolio. The loans have historically had a high recovery rate in the event of default. Furthermore, because the loans in a CLO structure are numerous and spread across a variety of types of borrowers, investors may benefit from diversification in a broader portfolio. In addition, the portfolios are often enhanced by loan criteria that require, for example, that 95% of the portfolio be invested in senior secured loans.

Also, since the underlying loans are generally  liquid and trade on the secondary market, the value of the CLO changes as the price of the underlying loans change. The CLO can be “marked to market,” so there is the potential for capital appreciation prior to maturity. Generally equity investors are the main beneficiaries of capital appreciation (or depreciation), though if the entire value of the CLO rises, senior and mezzanine investors generally benefit from capital gains as well, as a reflection of the lower risk that capital appreciation brings to the CLO structure.

Because of the diversification of the loans and the three-tranche structure of CLOs, the senior and mezzanine tranches are generally considered to be investment grade, with the senior tranche receiving the highest rating, followed by the mezzanine tranche. Equity tranches may or may not be rated, depending on the CLO and the objectives of the CLO manager.

CLOs, an Illustrative Example

To illustrate the CLO structure, imagine a $100 million CLO with 100 loans, with total loan interest payments equaling $4 million, or 4% of the $100 million total, made of individual loans paying various rates of interest. Senior investors, representing 40% of the total investment or $40 million, are paid 2%; mezzanine investors, another 40% of the total investment, are paid 4%; and the remaining 20% equity investment ($20 million) would expect to earn a rate of 8% provided all loans are paid in full. If there are no defaults, investors will be paid according to that prescribed schedule.

In the event that 2% of the loans default, senior and mezzanine investors would be paid in full (principal plus 2% and 4% respectively), and equity investors would ostensibly lose 1/10 of their original investment (2% of the total 20% invested). Equity shareholders would receive 8% on their remaining invested capital ($18 million), along with the residual value of the defaulted loans.

Although CLOs can be more complex than individual bank loans, they offer investors a structure that can enable  them to meet their individual risk requirements. CLOs also offer the benefit of a higher degree of diversification and take advantage of economy scale to allow for a wider variety of investment opportunities. CLOs have come to play a key role in the investment portfolios of a varietyof investors, from the most conservative institutions to hedge funds to accredited investors alike.

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