Fred Hubler | Forbes
New asset classes do not come along very often, but there are some unique ones worth investigating. One that you may not have much deal exposure to is called a collateralized loan obligation or CLO. CLOs are not new, having been around since banks and insurance companies started to use CLO technology for regulatory capital relief in the 1990s. But it is now a one trillion dollar market in the USA alone and product sponsors are bringing this access to retail accredited investors by using CLO funds. Over the years, the structure evolved to what is now; a core fixed income asset class alternative. This article will focus on CLOs created post-2008 financial crisis, specifically those referred to as CLO 2.0.
CLO Structure: The loan indenture details the structure. It will detail the asset eligibility criteria and the priority of interest and principal payments to the various debt and equity holders. In general CLO 2.0 tend to have the following criteria:
Diversification Requirements: Most CLO assets must exhibit diversification across individual issuers and industries.
Rating Requirements: The portfolio’s average rating must meet specified standards, with limitations on CCC-rated loans within a CLO.
• Loans must maintain enough spread to pay expenses and interest to the various tranche holders and there are restrictions on the maturity of the underlying loans and that must be shorter than the maturity of the CLO liabilities
• Limitations on trading activity of the collateral manager, thus adding further protection around the CLO assets.
Technically a CLO is a special purpose vehicle (SPV). This structure issues debt and equity to purchase assets. You can think of it like a small company that issues debt and equity to fund the loan making. CLOs also have a management team, called a collateral manager and that manager is responsible for buying and managing the assets in the CLO.
Most CLOs have multiple classes (AAA-BB) and an additional equity class that is used to purchase first senior secured loans to large companies. A CLO has very strict governing documents which will detail what the management team can and cannot do, how cash flows are used. There are different types of CLOs and many managers in this space now.
Benefits And Risks
Benefits include:
• CLO liabilities are floating rate so as interest rates increase, so does the interest of the CLO.
• High spread- CLOs typically yield more and have wider spread than similar rates of corporate debts.
• Low historic rates of default vs. similarity rated corporate bonds.
Risks:
Default risk- Loans in CLOs typically have more leverage than investment grade corporate debt and have a higher propensity to default. However, many CLO tranches are structured with future defaults in mind and the CLO manager works full time to reduce this risk.
• Mark to market risk- CLO’s bonds have average lives of seven years + and when interest rates change, they can have significant price volatility . Mark to market can work in the investors favor, but I see it as a risk.
• Liquidity Risk- CLO investments are less liquid than corporate bonds. The cost of entering and exiting an individual CLO position may be more expensive.
A Different Point Of View
CLOs are another arrow in your fixed income quiver. Most top performing CLOs have a track record of dealing with tricky interest rate cycles. When there is a shock to the market and loans go down in value, the top CLO firms use that as a buying opportunity to buy fixed income under par.
Another way to think of CLOs is that of a head chef. The CLO takes the diverse ingredients (the portfolio of loans) and makes meals from these ingredients (in the form of different CLO tranches). Adding CLOs to your options should increase exposure to a diversified portfolio of senior secured loans. It is a different way to play the fixed income market and like all investments, the management team matters.
Much like the specials list at your favorite restaurant, not every dish is one that you like, perhaps it contains something you’re allergic to, or aren’t in the mood for; not every CLO is suited for every investor. They offer a diverse menu of investment opportunities, each with unique risk profiles and potential returns. Some CLO tranches might contain underlying assets that don’t align with your investment appetite or risk tolerance, much like avoiding a dish that contains ingredients you’re not fond of or can’t consume. Just as a restaurant special might feature an exotic ingredient that excites one diner but repels another, a CLO can include loans from different industries or credit qualities that might appeal to some investors while deterring others.
Do your homework when looking at CLO’s; this site gives you a concise definition and this site shows thirty years of defaults (or lack thereof).
Just as you trust the chef’s expertise in crafting the specials, investors rely on the CLO manager’s ability to select and manage the pool of loans effectively. A seasoned chef knows how to balance flavors and create a dish that is both appealing and innovative, even if it isn’t everyone’s favorite. Similarly, a skilled CLO manager selects a blend of loans intended to optimize returns while managing risks, though not every CLO will suit every investor’s taste or financial goals. Thus, while the specials and CLOs offer exciting and potentially rewarding choices, they both require careful consideration and an understanding of personal preferences and tolerances to make the best selection.
Securities are offered through Arkadios Capital. Member FINRA/SIPC. Advisory services are offered through Creative Capital Wealth Management Group. Creative Capital Wealth Management Group and Arkadios are not affiliated through any ownership.
This material was created for educational and informational purposes only and is not intended as tax, legal or investment advice.
