CLOs: how scared should we be?

CLOs: how scared should we be?

We shouldn’t be! That’s the irony.

Fear makes strangers of those who would otherwise be our friends. It causes us to shun good opportunities when they come along.

It’s one of the reasons investment specialists should pay more attention to CLOs.

There is no rational reason to exclude CLOs from fixed income portfolios. The yields they offer are comparable to the individual tranche ratings they receive. They represent an institutional quality solution at a time when interest rates remain historically low, providing valuable risk premiums difficult to find in the present market environment. 

Institutional investors and family offices have long considered CLOs as valuable portfolio components. When they don’t have the in-house expertise, they rent or hire the talent. 

Yes, but what on earth are CLOs?

We should probably explain what CLOs are. They’re a form of structured credit, where the coupons and principal are backed by a diverse pool of senior secured bank loans that act as collateral. The debt issued by CLOs is divided into separate tranches. Each tranche has a different risk-return profile and is based on its priority of claim from the cash flows produced by the underlying loan pool.

Most of the underlying collateral pool from a CLO consists of first-lien senior-secured bank loans, which are also known at leveraged loans. These rank first in priority of payment in the borrower's capital structure in the event of bankruptcy, ahead of unsecured debt.

This collateral pool is purchased by issuing debt and equity in different tranches, where each have different risk-return profiles. This is determined by the tranches' priority of claim on the cash flow that is produced by the underlying loan pool and cascades down the CLO structure. 

It similar to a champagne tower: the top glasses need to be filled first before the others below receive their share of cash. 

Why CLOs are often misunderstood

The problem lies with the name CLO. It is a three-letter acronym, which stands for “collateralized loan obligation”.

This term on its own is about as clear as mud to most normal people. To compound matters, its name is easily mixed with its less popular cousin the CDO: the collateralized debt obligation. 

The mechanics behind CLOs and CDOs are similar. Both involve a pool of collateral that’s split into tranches and receives cascading cashflows. However, that’s where the similarity ends. They are very different securities.

Unlike CLOs, CDOs gained a great deal of notoriety during the financial crisis in 2008. A particular set of CDOs were to blame. They used risky mortgages as collateral and the borrowers of these mortgages couldn’t make the monthly payments.

Consequently, there were shortfalls in the cash flows that were supposed to cascade down the CDO. This eventually led to defaults.

CLOs by contrast, are backed by corporate credit in the form of leveraged loans. In stark comparison to the subprime mortgage market, leveraged loans are well-regulated and there are specific limits on the amount of leverage used.

Furthermore, CLOs had little to do with the financial crisis. The market for CLOs only developed after the financial crisis. In fact, no triple-A or double-A CLO tranche has ever defaulted. And, even if there was a risk of default, the loans acting as collateral are extremely well covered by analysts. The risks are therefore, far better understood for these loans.

CLOs have numerous safety features

Each CLO tranche has an overcollateralization ratio. These act like a covenant, which once tripped, redirect cash flows to purchase additional bank loan collateral or repay the senior-most CLO tranche.

They are also subject to tests, which assess the level of industry diversification and also the size of a CLO's exposure to non-secured loans.

When you look at the whole structure of the CLO, the vast majority of it is allocated to the triple-A rated tranche. In fact, there are often limits on the size of the triple-C tranche, which influences the construction of the underlying collateral pool and helps contain negative credit drift.

The CLO managers also actively manage the loan pool to protect debt and equity holders. Furthermore, most CLOs are not mark-to-market vehicles. Subsequently, there are high hurdles to meet before collateral liquidation is triggered, which means the loan pool has some immunity to market volatility.

What are the risks?

During the lockdown caused by the pandemic, there were a slew of rating agency downgrades that rippled through CLO structures. This placed pressure on CLOs as they can only hold a limited number of low-rated bonds before tests are tripped.

However, the market has since recovered and CLO issuance volumes are once again picking up. In fact, the default rate for the entire CLO market remains unchanged, which has been less than 1.0% since 1991.

The economic crisis unleashed by the Coronavirus pandemic has been hugely disruptive. Investors face an extended period of uncertainty, which will bring challenges and moments of market stress. CLOs could, however, be a force for stability and not anxiety. 

They shouldn’t be feared or shunned. They should be understood and appropriately embraced!