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CLOs: How They Work
Laila Kollmorgen, CFA
Portfolio Manager, CLO Tranche
Collateralized loan obligations (CLOs) are attracting increasing attention as investors broaden their horizons in the search for yield. While CLOs have historically yielded attractive performance versus other fixed income strategies, some investors may be intimidated by their complexity.
What is a CLO?
A CLO is a portfolio of predominantly leveraged loans that is securitized and managed as a fund. Each CLO is structured as a series of “tranches,” or groups of interest-paying bonds, along with a small portion of equity.
CLOs have changed a lot over the years, getting better with age. The current vintage, CLO 3.0, began in 2014 and aimed to reduce risk by eliminating high yield bonds and adhering to the Volcker Rule and other new regulations. In 2020, the Volcker Rule was further amended, and high yield bonds are now allowed back into CLOs, though they tend to make up only a small portion of CLO assets.
The vast majority of CLOs are called arbitrage CLOs because they aim to capture the excess spread between the inflows from payments of interest and principal on the leveraged loans and the outflows of management fees and other costs. The portfolio consists predominantly of leveraged bank loans (assets) and the classes of CLO debt (liabilities), with the equity investors receiving any excess cash flows after the debt investors are paid in full. The market for arbitrage CLOs is valued at $959 billion globally, with about 83% issued in the US and 17% in Europe.1
What are leveraged loans, and what part do they play in CLOs?
Leveraged loans are more than simply the underlying collateral for CLOs: They’re the fuel that powers CLOs’ historically attractive income streams and the first of several levels of potential risk mitigation built into the CLO structure.
Standard & Poor’s defines leveraged loans as senior secured bank loans rated BB+ or lower (i.e., below investment grade) or yielding at least 125 basis points above a benchmark interest rate (typically Libor2 or SOFR in the US and Euribor in Europe) and secured by a first or second lien.3 Several characteristics make leveraged loans particularly suitable for securitizations. They:
Pay interest on a consistent monthly or quarterly basis;
Trade in a highly liquid secondary market;
Have a historically high recovery rate in the event of default; and
Originate from a large, diversified group of issuers.
As of 30 June 2021, the amount of leveraged bank loans outstanding was $1.26 trillion in the US and €252 billion in Europe.4
Who issues, manages, and owns CLOs?
CLOs are issued and managed by asset managers. Of the approximately 175 CLO managers5 with post-crisis deals under management worldwide, PineBridge has found about two-thirds are in the US and the remaining third are in Europe.
Ownership of CLOs varies by tranche. The senior-most tranches are mainly owned by insurance companies (which favor income-producing investments) as well as banks (which need high-quality capital to meet regulatory requirements). The equity tranche is the riskiest of the typical tranches, offers potential upside and a degree of control, and appeals to a wider universe of investors.
How do CLOs work?
CLOs combine multiple elements with the goal of generating attractive returns through income and capital appreciation. CLO tranches are ranked highest to lowest in order of credit quality, asset size, and income stream – with the lowest tranche taking the greatest amount of risk, in comparison to the tranches above it in seniority.
Tranches Allocate Assets, Income, and Risk
Typical CLO tranche structure
Source: Citibank as of 30 September 2021.
Although leveraged loans themselves are rated below investment grade, most CLO tranches are typically rated investment grade because they benefit from diversification, credit enhancements, and subordination of cash flows.
Cash flows are the lifeblood of a CLO: They determine the distribution of income and principal, which determines the return on investment. The key concept is that distributions are paid sequentially starting with the senior-most tranche until each loan tranche has been paid its full distribution. Equity-tranche holders absorb costs and receive the residual distributions once the costs have been paid.
How do CLOs aim to mitigate risk?
Typically, CLOs have covenants that require the manager to test the portfolio’s ability to cover its interest and principal payments monthly. Coverage tests are a vital mechanism to detect and correct collateral deterioration, which directly affects the allocation of cash flows. Among the many such tests, the most common are the interest coverage6 and over-collateralization7 tests.
If the tests come up short, the manager must take cash flows from the lowest debt and equity-tranche holders and divert them to retire the loan tranches in order of seniority.
Coverage tests are one of several risk protections built into the CLO structure. Others include collateral concentration limits, borrower diversification, and borrower size requirements.
To learn even more about CLOs, read our full CLO primer, “Seeing Beyond the Complexity: An Introduction to Collateralized Loan Obligations.”
Footnotes
1 Source: Bank of America Global Research as of 31 July 2021.
2 Libor references should be considered illustrative, as this rate is effectively ceasing by the end of 2021. Please review “Risks Related to the Discontinuance of the London Interbank Offered Rate (“Libor”)” found at the end of this presentation for more information regarding this transition.
3 Source: S&P Global Market Intelligence, Leveraged Commentary & Data (LCD): Leveraged Loan Primer, as of 30 September 2021.
4 Source: Morgan Stanley research, “Global CLOs: CLO Tracker July 2021 – Milestone,” and S&P/LCD as of 9 July 2021.
5 Source: Intex as of 2 December 2020.
6 The income generated by the underlying pool of loans must be greater than the interest due on the outstanding debt in the CLO.
7 The principal amount of the underlying pool of loans must be greater than the principal amount of outstanding CLO tranches.
Disclosure
Investing involves risk, including possible loss of principal. The information presented herein is for illustrative purposes only and should not be considered reflective of any particular security, strategy, or investment product. It represents a general assessment of the markets at a specific time and is not a guarantee of future performance results or market movement. This material does not constitute investment, financial, legal, tax, or other advice; investment research or a product of any research department; an offer to sell, or the solicitation of an offer to purchase any security or interest in a fund; or a recommendation for any investment product or strategy. PineBridge Investments is not soliciting or recommending any action based on information in this document. Any opinions, projections, or forward-looking statements expressed herein are solely those of the author, may differ from the views or opinions expressed by other areas of PineBridge Investments, and are only for general informational purposes as of the date indicated. Views may be based on third-party data that has not been independently verified. PineBridge Investments does not approve of or endorse any republication of this material. You are solely responsible for deciding whether any investment product or strategy is appropriate for you based upon your investment goals, financial situation and tolerance for risk.
Risks Related to the Discontinuance of the London Interbank Offered Rate (“Libor”)
Libor an estimate of the rate at which a sub-set of banks (known as the panel banks) could borrow money on an uncollateralized basis from other banks. The United Kingdom (the “UK”)’s Financial Conduct Authority (the “FCA”), which regulates Libor, has announced that it will not compel banks to contribute to Libor after 2021; the panel banks will still be required to submit the USD 1-month, 3-month, 6-month and 12-month Libor settings until 30 June 2023. As that date approaches the FCA could decide to require the continued publication of these settings on a synthetic basis, which would represent an approximation of each setting, in order to reduce disruption in the market. On 3 April 2018, the New York Federal Reserve Bank began publishing its alternative rate, the Secured Overnight Financing Rate (“SOFR”). The Bank of England followed suit on 23 April 2018 by publishing its proposed alternative rate, the Sterling Overnight Index Average (“SONIA”). Each of SOFR and SONIA significantly differ from Libor, both in the actual rate and how it is calculated, and therefore it is unclear whether and when markets will adopt either of these rates as a widely accepted replacement for Libor. If no widely accepted conventions develop, it is uncertain what effect broadly divergent interest rate calculation methodologies in the markets will have on the price and liquidity of loans and debt obligations held by the funds, securities issued by the funds and our ability to effectively mitigate interest rate risks.
The Alternative Reference Rate Committee confirmed that the 5 March 2021 announcements by the ICE Benchmark Administration Limited and the FCA on the future cessation and loss of the representativeness of the Libor benchmark rates constitutes a “benchmark transition event” with respect to all U.S. dollar Libor settings. A “benchmark transition event” may cause, or allow for, certain contracts to replace Libor with an alternative reference rate and such replacement could have a material and adverse effect on Libor-linked financial instruments.
As of the date of this presentation, no specific alternative rates have been selected in the market, although the Alternative Reference Rates Committee convened by the Board of Governors of the Federal Reserve System has made recommendations regarding a specified alternative rate based on a priority waterfall of alternative rates and certain bank regulators and the SEC are encouraging the adoption of such specified alternative rate. It is uncertain whether or for how long Libor will continue to be viewed as an acceptable market benchmark, what rate or rates could become accepted alternatives to Libor, or what the effect any such changes could have on the financial markets for Libor-linked financial instruments. Similar statements have been made by regulators with respect to the other Inter-Bank Offered Rates (“IBORs”). Certain products / strategies can undertake transactions in instruments that are valued using Libor or other IBOR rates or enter into contracts which determine payment obligations by reference to Libor or one of the other IBORs. Until their discontinuance, the products / strategies could continue to invest in instruments that reference Libor or the other IBORs. In advance of 2021, regulators and market participants are working to develop successor rates and transition mechanisms to amend existing instruments and contracts to replace an IBOR with a new rate. Nonetheless, the termination of Libor and the other IBORs presents risks to product / strategies investing in Libor-linked financial instruments. It is not possible at this point to identify those risks exhaustively, but they include the risk that an acceptable transition mechanism might not be found or might not be suitable for those products / strategies (as applicable). In addition, any alternative reference rate and any pricing adjustments required in connection with the transition from Libor or another IBOR could impose costs on, or might not be suitable for applicable products / strategies, resulting in costs incurred to close out positions and enter into replacement trades.
