Collateralized Loan Obligations 2020: A Comprehensive Guide

Collateralized loan obligations, or CLOs, are a type of asset-backed security that's been around since the 1980s.

They work by pooling together a large number of loans, typically from mid-market companies, and then packaging them into a single security that can be sold to investors.

This allows banks to free up capital and take on more loans, while also providing investors with a relatively stable source of income.

CLOs typically have a senior and junior tranche, with the senior tranche being the most secure and having the highest credit rating.

The senior tranche is usually the largest portion of the CLO, and it's the one that investors are most interested in because it has the lowest risk.

Investors are attracted to CLOs because they offer a higher yield than traditional bonds, but with a relatively low risk of default.

A collateralized loan obligation, or CLO, is a type of loan fund that's created by borrowing money from investors to purchase business loans. These loans are often made to companies that are below investment grade, rated BB+ or lower.

The CLO manager buys these loans, which are senior secured loans with priority on company cash flow and often backed by assets and inventory. The loans themselves act as both the collateral and the revenue stream for the investor in the CLO.

As of 30 September 2024, there was $1.39 trillion in leveraged loans outstanding in the US, and €295 billion in Europe. These loans are particularly suitable for securitizations due to their consistent interest payments, high liquidity in the secondary market, high recovery rate in the event of default, and diversified group of issuers.

Here are the four stages of the CLO lifecycle, which generally occur over eight to 10 years:

A CDO is an asset-backed security made up of a portfolio of debts. These debts can be anything from residential mortgages to corporate bonds, commercial real estate loans, credit card debt, or student loans.

CDOs can even be made up of other CDOs, creating a complex structure. This is because the debt they're backed by can be diverse and varied.

CDOs have faced significant default issues in the past, particularly during the Great Recession.

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A security is a financial instrument that gives the owner a right to payment. In the case of a collateralized loan obligation (CLO), the security provides the owner the right to payments from the CLO.

The CLO issues these securities in tranches, with each level representing a different amount of risk and potential reward. This is because the most senior tranche is AAA, which pays a lower return on the investment but receives priority on payments.

A junior tranche might be rated BB, which offers a higher coupon rate but comes with the risk that not enough money will be earned to pay off the senior securities and still make the payment on the junior levels.

Here's a breakdown of the different tranches and their corresponding risk levels:

Keep in mind that the risk level of a CLO security is directly tied to the risk level of the underlying loans.

The CLO market has experienced significant growth since the subprime mortgage crisis, with issuance volumes increasing exponentially in 2010. The market has remained robust and healthy, with a record $125 billion in new issuance in 2018.

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The majority of the market is represented by CLO vintages 2.0 and 3.0, which account for nearly all of the market today. This is according to Bank of America Global Research as of 30 September 2024.

In 2019, new CLO issuance declined to $118 billion, an 8 percent drop from the previous year's record. Despite this decline, the market remains strong and diverse.

The CLO market is established through a special purpose vehicle, which issues multiple tranches of debt to finance the acquisition of diversified leveraged loans. These loans are primarily 1 lien senior secured loans to issuers across several industries, including Healthcare & Pharmaceuticals, High Tech, and Business Services.

The issued tranches include rated debt and unrated equity, which provide a range of risk and reward profiles. This makes them potentially suitable for a wide range of investors, including banks, insurance companies, asset managers, pensions, and endowments.

The most prominent sub-sectors in the CLO market include:

The global CLO market is 83% USD CLOs and 17% EUR CLOs, with a strong presence on both sides of the Atlantic.

A collateralized loan obligation (CLO) is a complex structure that combines multiple elements to generate an above-average return via income and capital appreciation. It consists of tranches that hold the underlying loans, which typically account for about 90% of total assets.

The CLO lifecycle includes five stages: warehousing, ramp-up, reinvestment, non-call, and repayment and deleveraging. During the warehousing stage, the manager purchases the initial collateral before the closing date, which can take around 3-6 months.

The CLO structure benefits from diversification, credit enhancements, and subordination of cash flows, which typically results in most CLO tranches being rated investment grade. This is despite the underlying leveraged loans being rated below investment grade.

Here are the four stages of the CLO lifecycle:

The CLO manager can also sell equity rather than structured debt to raise funds, but equity is the riskiest of the investment options.

CLOs are complex structures that combine multiple elements with the goal of generating an above-average return via income and capital appreciation. They consist of tranches that hold the underlying loans, which typically account for about 90% of total assets, and a sliver of equity.

The tranches are ranked highest to lowest in order of credit quality, asset size, and income stream – and, thus, lowest to highest in order of riskiness. This ranking is crucial in determining the overall stability of the CLO.

Each CLO has a defined lifecycle that includes five stages. These stages are: warehousing, ramp-up, reinvestment, non-call, and repayment and deleveraging.

Here are the five stages in more detail:

The expansion period is a crucial stage in the life cycle of a collateralized loan obligation (CLO). It typically lasts for a set period, during which the CLO manager actively manages the loan portfolio.

The manager can sell some loans, buy others, and reinvest revenues received from assets in the collection. This active management helps to optimize the portfolio's performance and increase its value.

During the expansion period, investors might be prohibited from requesting their money back, a period referred to as a non-call period. This restriction is in place to allow the manager to focus on managing the portfolio without external interference.

The expansion period is a time for the CLO manager to put their skills and expertise to work, making strategic decisions to grow the portfolio and maximize returns.

Dedicated CLO managers actively manage the collateral pool through purchases and sales during the reinvestment period.

A good CLO manager will have a strong track record, disciplined credit process, and substantial infrastructure to support the investment process.

Investors should underwrite portfolios, structures, and managers to uncover investment opportunities.

MIM has been investing in CLOs for over 20 years, with investments across various sub-sectors.

The global CLO market has experienced tremendous growth, surpassing $1 trillion.

Here are some key potential benefits and investment considerations:

Investors should expect to see a strong track record from a CLO manager, as well as a disciplined credit process and substantial infrastructure to support the investment process.

CLOs can offer investors multiple benefits, including strong returns. Over the long term, CLO tranches have outperformed other corporate debt categories, including leveraged loans, high yield bonds, and investment grade bonds.

A key advantage of CLOs is their low interest-rate sensitivity. Leveraged loans and CLO tranches are floating-rate instruments, priced at a spread above a benchmark rate, which means their yields will move accordingly as interest rates rise or fall.

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CLOs have historically presented lower levels of principal losses relative to corporate debt and other securitized products. For example, among the approximately $500 billion of US CLOs issued from 1994-2009 and rated by S&P, only 0.86% experienced defaults, and an even smaller percentage of those, 0.40%, were originally rated BBB or higher.

Here are some key metrics demonstrating CLOs' attractive risk profile:

Overall, CLOs can provide investors with strong returns, low interest-rate sensitivity, and an attractive risk profile, making them a valuable addition to a diversified fixed income portfolio.

CLOs have outperformed other corporate debt categories, including leveraged loans, high yield bonds, and investment grade bonds, over the long term.

Strong returns have been a hallmark of CLOs, with a 10-year annualized return of 9.4% in the US, outpacing other credit asset classes.

CLOs have also outperformed on a risk-adjusted basis, generating higher Sharpe ratios than many other credit asset classes.

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Low interest-rate sensitivity is another benefit of CLOs, as they are floating-rate instruments that move less than fixed-rate instruments in response to interest rate changes.

This characteristic can be advantageous to investors in diversified fixed income portfolios.

Attractive risk profiles are a key feature of CLOs, with default and loss rates significantly lower than those of corporate debt and other securitized products.

In fact, only 0.86% of US CLOs issued from 1994-2009 experienced defaults, and an even smaller percentage of those were originally rated BBB or higher.

Loss rates for CLOs are also very low, with originally rated AAA-A tranches never experiencing a principal loss.

CLOs have consistently offered 60-100 basis points of excess spread compensation to traditional, AAA-rated structured finance investments due to their structural nuances and underwriting complexity.

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Some investments can be quite volatile, with their value fluctuating rapidly, such as those in the tech industry, which can experience sudden downturns.

Investing in the stock market carries inherent risks, including the possibility of losing some or all of your investment, as seen with the dot-com bubble in 2001.

Risk retention is a crucial concept in the CLO world. It requires managers to retain a portion of the ownership in the loan, essentially putting their own skin in the game.

In Europe, regulators established a 5% risk-retention requirement since 2010. This means that CLO managers must keep at least 5% of the ownership in that loan.

The idea behind risk retention is to remove the disconnect between loan approval and default risk. By making managers retain a portion of the ownership, they have a vested interest in ensuring the loan is sound.

The United States passed a similar rule in 2016, but it was overturned by the courts in 2018. The court cited the fact that the CLO does not issue the loan, but merely purchases it.

This shows that risk retention is a complex issue, and regulations can change over time. However, the concept remains an important one in the CLO world.

In the past, CLOs often included up to 10% of unsecured debt and high-yield bonds. But the Dodd-Frank Act changed this, and now CLOs no longer include any unsecured assets.

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A collateralized loan obligation (CLO) is a complex structure requiring a best-in-class valuation analysis. This is because CLOs involve bundling lower-quality bank loans together, which can be repackaged into securities of a different risk level than represented by the underlying loans.

CLOs have a nuanced valuation framework, with assumptions driving the value of CLO debt and equity being complex and not-so-common. An independent valuation professional with a depth of knowledge is best suited to manage the rigors of a CLO.

The debt issued by CLOs is divided into separate tranches, each with a different risk/return profile based on its rating and priority of claim on the cash flows produced by the underlying pool of loans. This is why CLO debt tranches are arranged with an AAA-rated tranche as the most senior, descending to AA, A, BBB, and BB-rated tranches.

A CLO's equity investors essentially own the underlying managed pool of loans, and the CLO debt investors finance that same pool of loans. This means that cash flows received from the underlying collateral are first used to pay the coupon on the AAA tranche, with the remaining cash flows used to pay the coupon on the AA tranche, and the remaining tranches in order of priority via a waterfall structure.

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Typical CLO equity IRRs range from 12 to 16 percent, commensurate with the inherent risk of the CLO equity's first loss position. This is because all underlying loan defaults accrue to the equity tranche first before directly impacting any of the more senior debt tranche principal balances.

Here's a breakdown of the key structural features of a CLO:

These features make CLOs complex structures requiring a best-in-class valuation analysis.

The issuance of a collateralized loan obligation (CLO) is a crucial step in its lifecycle. The CLO manager looks to investors to finance the endeavor by selling bonds at various risk levels, with a return on investment commensurate with the risk.

Insurance companies, large banks, and pension funds often purchase these securities. They offer senior-level debt that receives first call on revenues, with a rating of AAA or AA due to its least risk and lowest coupon rate.

Junior level debt is subordinate to senior level debt, meaning it only gets paid once the higher level debt is satisfied. These securities might get rated A or BBB, offering a better return but with a slightly higher risk.

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The CLO might also sell mezzanine level debt, typically considered high-risk but generating high-returns when paid. However, all debt investors above mezzanine debt investors have priority in payment, with ratings of BB or lower.

The CLO manager can also sell equity to raise capital, which is considered the riskiest level of investment. Hedge funds and venture capital investors are typically interested in this option, as they have a right to a portion of the profits the CLO eventually earns.

After the reinvestment period is over, the CLO manager cannot purchase or sell any more loans. Revenues from the underlying assets then go toward repaying the debt investors, in order of priority for each tranche.

The AAA tranche gets paid first, with the lowest risk exposure and the fastest repayment time. Once the AAA tranche is paid, the AA tranche is next, and so on, until all debt investors have been satisfied.

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In 2020, the downgrade percentage of issuers within the leveraged loan universe reached 47%, but only 2% of US CLO bonds by volume and 9% by count were downgraded.

The vast majority of these downgrades, 95%, occurred in Single-B, and BB-rated tranches and to a lesser extent BBB-rated tranches.

Approximately 54% of CLO tranches downgraded in 2020 have since been upgraded or had their rating withdrawn as a result of paydowns, refinancings, and resets.

Data on Moody’s rated CLOs from 1993-2020 show an impairment rate of 0.6%, with no principal losses reaching AA and AAA-rated bonds.

A key structural protection in CLOs is credit enhancement in the form of subordination, which can absorb collateral losses before they impact bonds.

Excess spread is another structural feature that helps protect investors in senior tranches during times of stress.

The CLO structure penalizes excess holdings of loans rated Caa1/CCC+ or below, and Collateral Quality Tests (CQTs) restrict a manager's ability to trade and add more risk to the portfolio.

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Coverage tests ensure tranche interest and principal bond payments, and if there is collateral deterioration, equity distributions are redirected to buy additional collateral to bolster the structure.

Here are the key structural protections in CLOs:

These structural features, taken together, are designed to help senior tranches withstand significant collateral losses.