Together with…
Brief historical background
Collateralized Loan Obligations (CLOs) trace their origins to the late 1980s when financial innovators began exploring ways to bundle and securitize loans, including corporate loans, into investment products. In the early 1990s, CLOs emerged as a distinct financial instrument. These structured finance products pooled together portfolios of leveraged loans, typically those extended to corporations with below-investment-grade credit ratings.
By the early 2000s, CLOs had gained immense popularity, driven by a quest for higher yields in a low-interest-rate environment. During the 2007-2008 financial crisis most structured credit products exposed vulnerabilities, with the exception of the CLO market. It’s important not to group CLOs with other securities such as CDOs, CBOs other ABSs that resulted in significant losses. While CLOs decreased in price (mark to market valuations), likewise all government and corporate bonds and other securities, they continued to distribute interests. In particular most non-rated CLO subordinated tranches, from 2009-10 continued to generate very high quarterly distributions and finally returned 15-20% IRR.
The Great Financial Crisis led to a stop of new CLO issuance for a few years but in 2011 the market slowly reopened for CLOs as professional investors appreciated and distinguished the performance of a properly and actively managed CLO’s structure versus complex and opaque products like CBOs, CDOs and similar securities. The new CLOs 2.0 have tighter degrees of protection, as rating agencies valuations criteria required more collateral and stricter rules to assign credit ratings.
Throughout the 2010s, CLOs reaffirmed as attractive investment vehicles, with structures evolving and continuing to align the interests of CLO managers and investors. Also, further attention has been paid to compliance and concentration, in order to further improve industrial sectors diversification (healthcare, tech, consumers, auto, food, business services, etc). The CLO market continued to evolve in the 2020s, influenced by economic conditions and ongoing regulatory adjustments, reaching a total outstanding issuance over $1 trillion. It has become the largest Asset Back Securities market and now it is near the size of the High Yield Bond market.
What is a CLO?
Collateralized Loan Obligations (CLOs) are a type of structured financial product. In a CLO, a company/fund (a Special Purpose Vehicle – SPV) issues bonds that are backed by a diversified portfolio of bank loans. Only large bank loans granted to rated corporations can be included in a CLO portfolio.
CLOs main features
These loans are characterized by several key features:
- Loan Types: The underlying assets in a CLO portfolio are typically composed of senior secured loans often referred to as leveraged loans. These loans have historically much higher recovery values than equivalent bonds because they are collateralised by eligible assets. All loans are Broadly Syndicated Loans (BSL) made by major banks to large corporations with established credit ratings and are syndicated to many banks and investors.
- Loan Tenor: The loans typically have medium-term maturities, commonly ranging from 5 to 6 years. This means that the borrowing corporations have several years to repay the principal amount of the loans. In a CLO portfolio there are also loans with shorter maturities purchased in the secondary market.
- Credit Quality: The borrowers of these loans are rated BB or B by at least two of the 3 major credit rating agencies, (Moodys’, S&P and Fitch).
- Interest Rate: Borrowers in these leveraged loans usually pay a floating interest rate.
- Floating Rate: The loans within a CLO portfolio typically have floating interest rates. These interest rates are linked to benchmark rates (SOFR/ Libor or Euribor) influenced by central banks (Federal Reserve or ECB). This means that the interest income generated by the loans varies over time.
- Cash Flow: The cash flows generated from interest payments and principal repayments on these bank loans form the basis for payments to CLO bondholders.
CLOs management
- CLO Securities: The loan portfolio of a CLO is financed with the issuance of various securities (tranches) ranging from AAA rating to non-rated bonds, reflecting different level or risk/return and priority of payments. The senior tranches receive payments before subordinated bonds (also called junior or equity notes) which have a higher risk compensated by higher returns.
- CLO Subordinated notes receive on a quarterly basis all the excess spread interests deriving from the difference of all the interest earned on all the loans in the CLO portfolio minus the interests paid to the more senior tranches (AAAs to BBs). An investor in subordinated CLO notes is like the shareholder of a simplified bank that makes loans to corporates (portfolio of loans of the CLO) and funds itself via deposit and issuance of bonds, making the positive spread between the two. The advantage in the CLO structures is that the investor in the Sub-Note decides when to terminate the funding and it’s not subject to margin calls. For this reason, investors in Sub-Notes during the GFC have weather the market stress and were able to recover high distributions that yielded double digits returns.
- Diversification: CLOs hold a diversified portfolio of 150-250 Broadly Syndicate Loans; these are subjects to controls from the rating agencies that also require spreading exposure across multiple borrowers and industries.
- CLO Manager: The selection and active management of a CLO’s portfolios is performed by established and specialised Credit Asset Managers. When a new Collateralized Loan Obligation (CLO) is issued, a CLO Manager is mandated to purchase the loans in the Primary and Secondary loan markets and continues to manage / trade the portfolio until the final redemption of the CLO. It earns a management fee of around 0.40-0.50% and a performance fee only above a 12 % cash IRR in order to align his interest with the investors in the CLO securities.
- CLO Trustee Report: Each month the independent trustee bank that has the custody of the loans of a CLO, prepares a comprehensive report listing all the loans’ details and the trading activity occurred during the previous months. These reports not only show all the various cashflows but also serve to highlight compliance with various tests that rating agencies require the CLO to meet.
Conclusion
To wrap up, CLOs are structured financial instruments that have been present in the market for several years. CLOs are bonds issued by companies (SPV/Fund) owning a portfolio of 150-250 different bank loans.
CLOs vary in terms of return and risk providing the choice to purchase different securities (tranches) with different credit ratings. They are extremely diversified in term of exposure, and they are actively managed by professional asset managers.
Investment in CLOs have historically outperformed all fixed income products of equivalent rating. Subordinated CLO notes have even outperformed most Equity indices in the medium term.
In the following insights we will delve into Avenida CLOs Funds related topics.
Join ThePlatform to have full access to all analysis and content:
https://www.theplatform.finance/registration/
Disclaimer: https://www.theplatform.finance/website-disclaimer/
