Securitized and managed as a fund, a portfolio of collateralized loan obligations is typically structured as a grouping of interest-paying bonds with a small equity component. The ultimate goal of a CLO is to generate a profit from the payments on a series of leveraged loans.
We go into significant detail regarding the structure and functioning of CLOs in our Introduction to CLOs article, so here we’ll focus on the nature of collateralized loan obligations vs other investment products. Specifically, we’ll take a look at CLOs vs bank loans, mortgage backed securities, asset-backed securities and credit default swaps.
To a degree, many CLOs are bank loans, in that CLOs are usually made up of a pool of below investment grade, first lien, senior secured, syndicated corporate bank loans. CLOs also contain smaller allocations to other types of investments such as middle market loans and second lien loans.
However, unlike individual bank loans, the risk is spread over a collection of debts, so the portfolio can still generate returns for investors even if an individual borrower defaults. To help provide more protection, a CLO’s loan issuer and industry concentrations are diversified across a number of different industries.
It’s important to reiterate these individual bank loans typically carry sub-investment grade credit ratings, which means the issuer is considered more of a risk for default. The good news is these loans are senior in a company’s capital structure, so they’re potentially less risky than secured bonds — though default is still a possibility.
Now, with that said, bank loans do currently offer some of the highest yields in the fixed income market. However, given bank loans can only be held by institutional investors, CLOs give mainstream shareholders access to this asset class.
Also known as MBSs, mortgage backed securities are essentially bonds backed by real estate loans. Or, said more precisely, the income on real estate loans. They are similar to CLOs in that they are a grouping of debt. However, as covered above, CLOs are generally more diversified because they are supported by the debt of a wide variety of industries. The assets of those companies also collateralize them. Moreover, CLOs occupy senior positions in corporate capital streams. This gives CLO investors a bit more insulation against default.
MBSs, on the other hand, are tied specifically to real estate loans. Composed of a pool of mortgages owned by banks, credit unions and other mortgage lenders, financial institutions purchase them and package them into securities backed by the loans of which they are comprised. Prior to 2007, this was thought to be one of the safest investments of this type, because the default rate on real estate loans was very low. However, the introduction of derivatives and the resulting increase in leverage made these loans more prone to default. Moreover, the mortgage market was victimized by a lack of strict regulation, which left the door open for outright fraud to occur.
Regulators, having learned from that experience, have made today’s governing standards and protocols more stringent. MBS Issuances are now limited to government sponsored enterprises such as the Government National Mortgage Association, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation (aka Ginnie Mae, Fannie Mae and Freddie Mac). Certain private institutions also have the ability to issue them, however all included mortgages must be sourced from regulated and authorized institutions. They must also have one of the top two ratings from an accredited rating agency.
Abbreviated “ABS”, asset backed securities are supported by the income from personal loans, leases, credit cards and other types of receivables. Because home equity loans, automobile loans, credit card receivables, student loans and other expected cash flows making up these assets tend to lack liquidity, it’s difficult to market them to investors individually. Securitizing these obligations helps their originators potentially alleviate the risk of offering them, while creating potential income streams for investors.
Like CLOs, ABSs have a tiered structure, or “tranches” for investor participation. These positions correspond to the degree of risk an investor is willing to accept. The senior position, also known as the “A” tranche, represents the smallest degree of risk. The second tranche has a lower credit rating, however, it offers a higher rate of return. The issuer generally holds the “C” tier, as its low rating precludes offering it to investors.
If this sounds a lot like a CLO, it’s because the two are quite similar in terms of the way they are structured and operate. Again though, a CLO is backed by corporate debt and is highly diversified, where asset backed securities tend to focus on one particular aspect of consumer debt. MBSs are also sometimes looked upon as ABSs, as the two operate in a similar fashion, including paying a fixed rate of interest generated by the underlying assets. However, mortgage backed securities are tied specifically to mortgages, while asset backed securities are tied to other types of consumer debt, although this does include home equity loans.
Simply put, a credit default swap is like an insurance policy against the failure of a loan. The three entities involved in a CDS transaction are the borrower, the purchaser of the swap and the seller of the CDS.
Let’s say a company issues a $100 bond with a 10-year maturity. The person who buys that bond agrees to wait 10 years to get their money back, with the caveat they receive interest payments at specific intervals over that 10-year period. However, because there’s no guarantee that the company will be around in 10 years, the buyer of the bond makes a deal with a financial institution to guarantee repayment of the debt in the event the borrower defaults. What’s more, that institution can then sell the swap to another institution to profit from the deal.
This entails a great deal of speculation on the part of the institutions buying the swaps, as they are now betting the borrower won’t default. However, the deal also hinges on the buyer’s ability to pay the premiums until the bond matures. If both the borrower and the buyer default, the swap becomes worthless. Magnifying the risk to the economic system is the fact that a CDS can be sold over and over again, so if it goes bad in that fashion, a domino effect can result with defaults working their way through an entire economic system — which is what happened in 2007.
As covered above, CLOs also depend upon loan payments to generate revenues. However, they are more narrowly focused than CDSs and they have more protections built in for investors.
With their strong performance history, particularly through the financial crisis of the early 21st century, the CLO market has experienced significant growth. However, this asset class had long been mostly inaccessible to retail investors, until the emergence of exchange traded funds (ETF) specializing in the CLO market changed that situation.
This introduced more liquidity to the asset class. Plus, more safeguards have been instituted to provide more protection for highly rated CLO tranches. Further, the participation of money managers in this area has increased trading volumes considerably. As a result, the secondary market is quite active and the investor base is growing.
With that said, you’re still investing in the leveraged-loan market, albeit a potentially less risky aspect of it. “The default risk of CLOs is extremely low, even much better than many corporate high-yield bonds,” Wells Fargo CLO analyst David Preston said in an interview with Barron’s. And, in fact, of the more than 12,500 CLO tranches rated by the S&P Global, only 40 have ever defaulted—and none of them were AAA-rated, which is where ETFs primarily invest.
With that in mind, retail investors considering getting into CLOs should look for actively managed exchange-traded funds that invest only in the highest-rated tranches. This will ensure you layers of default protection, while preserving your potential to achieve higher yields than you might see with investment grade bonds.
Collateralized loan obligations are but one asset class among a new emerging range of alternative investments available to mainstream investors for portfolio diversification. These can also be used to create passive income streams. You’ll find a number of similar opportunities here at Yieldstreet, comprised of investment vehicles formerly available only to extremely high net worth individuals. Take a look around to see what Yieldstreet can do for you.
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