After the 2008 financial crisis, many Americans became keenly aware of collateralized mortgage obligations (CMOs) and collateralized loan obligations that held many subprime loans for residential mortgages. To jog your memory a bit, during the financial crisis, many borrowers of subprime mortgages began to default, which became the crux of the financial crisis. While the financial industry learned a hard lesson about the use of this type of derivative product, its allure has reemerged, and the latest attraction are collateralized loan obligations (CLOs).
What are collateralized loan obligations?
CLOs have regained a significant amount of popularity in recent years, and the CLO market is booming. While many markets began to shake after the COVID-19 pandemic, the CLO market remained strong. While many investors are still watching the CLO market, it has proven to be a resilient financial instrument that can weather the storm. This is the reason many investors are hungry to tap into the CLO market.
In addition to its resiliency, CLOs deliver huge payouts, and their existence increases banks' willingness to loan money to below-investment-grade companies. Sounds like a win-win for all parties involved! For this reason, investing in a collateralized loan obligation is the latest rage in the financial industry.
CLO stands for collateralized loan obligation. A CLO is a type of special-purpose vehicle. This vehicle is similar to collateralized debt obligation (CDO), but it is a lot less complex, therefore less risky. This asset-backed security (ABS) is a group of corporate debt purchased with money from various groups of investors. The debt obligations are pooled together in tranches, with each debt tranche carrying a varying degree of risk.
The pooling process of these loan obligations together is called securitization. Securitization makes investment in a CLO less risky for investors since their portfolio will be diversified because it will hold multiple loans. In this way, no single investor will hold a single risky investment and thereby potentially lose their entire investment.
What type of debt does a CLO hold?
The collateral pool that comprises CLOs are generally held in the form of below-investment-grade, first-lien, senior-secured, syndicated bank loans. The collateral pool may also consist of second liens and equity. Below-investment-grade loans are typically riskier investments because they have a higher risk of default than investment-grade bonds, and investing in this type of instrument requires the investor to have the capacity to assume this risk. For this reason, many investors in CLOs are institutional investors. An institutional investor could be a bank, mutual fund, insurance company, pension fund, or hedge fund.
When investors invest in CLO loans, they are ultimately purchasing loans that have been packaged together by a CLO asset manager. The asset manager manages this instrument over a reinvestment period. During this period, the manager sells the CLO based on the debt tranche that it occupies.
This allows the investor to invest in the type of security that is conducive to the investor’s risk tolerance. The tranches range from the equity tranche (most risky investment) to the AAA tranche (least risky investments). Each tranche holds specified credit quality, risk of loss, and cash flow distribution.
This type of investment vehicle is typically attractive to investors because of the associated scheduled payments and high yields -- as long as the underlying loan obligee does not default.
Leverage loans and CLOs
In the CLO market, there are approximately 1.2 trillion leverage loans, accounting for nearly half of the leveraged loans outstanding. Leveraged loans act as collateral loans for CLOs. These types of loans are classified as syndicated loans that offer financing for below-investment-grade companies that do not have the creditworthiness to receive a traditional loan. These companies typically have high levels of debt and a less-than-favorable credit rating. But do not think of a small business when you think of CLOs -- some pretty well-known companies are managed using leveraged loans, such as Dunkin' Donuts and Hilton Worldwide.
These types of loans are what many CLOs are made of. These are ultimately pretty risky investments, but they deliver high yields, which is why the leveraged loan market is attractive to many investors.
CLOs typically fall into two categories: rated and unrated. Investments that fall into the rated category will typically receive principal and interest payments, while investments that fall into the unrated category will typically receive residual cash flows. Residual cash flows are the income that is left over all fees and the principal and interest payments to debt tranches are paid. These types of payments are generally distributed to equity investors.
When it comes to equity investors, as you may imagine, this asset class runs the most risk of receiving the lowest dividend payout. Equity investors also run the risk of receiving no dividends at all! This is so because CLOs have a waterfall payout structure, and if any investment defaults, the equity investor tranche is the first class to take the hit of the loss. Equities represent less than 10% of CLOs, are usually held by nonbank investors, and are at the bottom of the CLO food chain.
Where are CLOs issued?
Although some CLO issues can be found in Delaware, CLO issuers are primarily in the Cayman Islands. Being located in a tax haven prevents the issuer from being exposed to corporate taxation.
What are the advantages of collateralized loan obligations?
Many investors in the CLO market wonder if the use of this type of derivative product will cause the next financial crisis. Some believe that it will not, while others believe that in the event of an economic downturn, companies that cannot hold below-grade investments will have to sell off CLOs, causing another financial panic.
For now, what we do know is that CLO markets offer investors many benefits:
- A higher rate of return
- The hedge against inflation
- The CLO pool of loans are more diversified.
- CLOs increase liquidity for banks to loan money.
The Millionacres bottom line
If you think now is the time to hop in the CLO market, consulting with a competent advisor is your safest bet. CLO investing is quite complex, so don't go it alone.