With higher relative yields, built-in risk protection, and historical outperformance in periods of rising rates, it’s time to get to know CLOs and how they are structured.
What Is a Collateralized Loan Obligation?
A collateralized loan obligation (CLO) is a portfolio of predominantly senior secured loans that is securitized and actively managed. Each CLO issues a series of floating rate bonds, along with a first-loss equity tranche. The tranches differ in terms of subordination and priority—and, thus, lowest to highest in order of riskiness. Major rating agencies, such as Moody’s and Standard & Poors, provide ratings on the investment risk of these individual tranches as they do within other areas of fixed income.
Cash flows from the underlying loans of a CLO are used to pay interest on the debt tranches, and get distributed based on a “waterfall” whereby cashflows are paid sequentially starting with the senior-most tranche until each tranche has been paid its full distribution. Equity-tranche holders receive the residual distributions, net of costs. Principal distributions are similarly applied first to the most senior tranches.
Understanding the Structure of CLOs
Understanding the Structure of CLOs
Source: PineBridge Investments. This is not an offer to buy or sell, or recommendation to buy or sell any of the securities mentioned herein.
CLOs are actively managed vehicles—i.e., they have a reinvestment period during which the manager can buy and sell loans within the portfolio and reinvest within the parameters set forth by the governing documents. Managers can add value by reinvesting and positioning portfolios to increase returns in benign economic environments and protect against downside risk during weaker economic times.
Built-in Risk Protection: The CLO Structure Is Built to Last
The strong historical performance of the asset class is a testament to the built-in risk protections of CLOs, which starts with the strength of its underlying collateral, i.e. the likelihood the collateral pool will continue to generate sufficient cash flow over the life of a CLO. Leveraged loans (the underlying collateral of CLOs) are senior and secured, meaning they have the senior-most claim on all the issuer’s assets in the event of a bankruptcy. Historically, leveraged loans’ senior secured status has consistently led to lower default rates and higher recoveries compared to unsecured high-yield bonds. CLOs further reduce risk by creating diverse portfolios of leveraged loans—typically 150–250 borrowers—and actively managing that portfolio.
In addition to the attractive risk profile and active management of its underlying collateral, the structure of CLOs helps mitigate risk. For example, coverage tests are a vital mechanism to detect and correct collateral deterioration, which directly affects the allocation of cash flows. All CLOs have covenants that require the manager to test the portfolio’s ability to cover its interest payments monthly. Among the many such tests, the most common are the interest coverage and overcollateralization tests. Interest coverage dictates that the income generated by the underlying pool of loans must be greater than the interest due on the outstanding debt in the CLO, while overcollateralization requires the principal amount of the underlying pool of loans to be greater than the principal amount of outstanding CLO tranches. As shown below, if the tests come up short, cash flows are diverted from more junior tranches to pay off the most senior tranches first, until these failures are cured.
CLOs Are Structured to Minimize Defaults
CLOs Are Structured to Minimize Defaults
Source: VanEck. This is not an offer to buy or sell, or recommendation to buy or sell any of the securities mentioned herein.
CLOs Are Less Sensitive to Changes in Interest Rates
In addition to their strong risk profiles, CLOs are floating rate instruments, reflective of the underlying floating-rate senior loans they hold. This means they have virtually no price sensitivity to changes in interest rates, and coupon payments increase as rates go up. As a result, CLOs have historically outperformed in periods of rising rates. In fact, investment-grade (IG) CLOs have historically provided a more attractive risk/return profile relative to other similarly rated areas of fixed income, such as IG corporate bonds and IG floating rate notes.
Common Misperceptions about CLOs
CLOs fall into the structured credit category, an asset class that includes collateralized debt obligations that held subprime mortgages, a market segment at the epicenter of the 2008 Global Financial Crisis. As a result, the perception exists among some investors that all structured credit is inherently riskier than more traditional fixed income. Historical evidence, however, tells a much different story, especially for CLOs.
CLOs have been tested through two major market crises. Through both the Global Financial Crisis and COVID-19 drawdown, the asset class ultimately experienced fewer defaults than corporate bonds of the same rating. For example, of the approximately $500B of U.S. CLOs issued from 1994-2009 and rated by S&P, only 0.88% experienced defaults. In the higher rated AAA and AA CLO tranches, there have been zero defaults.
Further, an experienced CLO investor can analyze each individual credit within a CLO as well as the structural features of each deal to understand the risk and return potential. CLO managers are analyzed to understand their style and process, and diversified portfolios can be constructed that have exposure to a wide variety of issuers and sectors, managers and vintages. Doing this analysis requires specialized knowledge, sophisticated systems and deep experience in the CLO market.
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This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.
An investment in a Collateralized Loan Obligation (CLO) may be subject to risks which include, among others, debt securities, LIBOR Replacement, foreign currency, foreign securities, investment focus, newly-issued securities, extended settlement, management, derivatives, cash transactions, market, operational, trading issues, and non-diversified risks. CLOs may also be subject to liquidity, interest rate, floating rate obligations, credit, call, extension, high yield securities, income, valuation, privately-issued securities, covenant lite loans, default of the underlying asset and CLO manager risks, all of which may adversely affect the value of the investment.
All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future results.
