Band William Sokol
Senior Product Manager
With higher relative yields, built-in risk protection, and historical outperformance during rising rates, it’s time to get to know CLOs and their structure.
What is a secured loan bond?
A secured loan obligation (CLO) is a portfolio of primarily senior secured loans that is securitized and actively managed. Each CLO issues a series of floating rate notes, as well as a tranche of first loss shares. The tranches differ in terms of subordination and priority, and therefore from lowest to highest in order of risk. The major rating agencies, such as Moody’s and Standard & Poors, provide ratings on the investment risk of these individual tranches as they do in other areas of fixed income securities.
Cash flows from the underlying loans of a CLO are used to pay interest on debt tranches and are distributed on a “cascade” basis in which cash flows are paid sequentially beginning with the highest slice until each slice has received its full distribution. Holders of tranches of shares receive the residual distributions, net of fees. Similarly, capital distributions are applied first to the most senior tranches.
Understanding the structure of CLOs
Source: PineBridge Investments. This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities mentioned herein.
CLOs are actively managed vehicles, i.e. they reinvestment period during which the manager can buy and sell loans within the portfolio and reinvest within the parameters defined by the governing documents. Managers can add value by reinvesting and positioning portfolios to increase returns in favorable economic environments and protect against downside risk during economic downturns.
Built-in risk protection: CLO structure is built to last
The strong historical performance of the asset class speaks to the built-in risk protection of CLOs, which begins with the strength of its underlying collateral, i.e. the likelihood that the collateral pool will continue to generate sufficient cash flow over the life of a CLO. . Leveraged loans (the underlying collateral in CLOs) are senior and secured, meaning they have the highest claim on all of the issuer’s assets in the event of bankruptcy. Historically, the senior secured status of leveraged loans has consistently resulted in lower default rates and higher recoveries compared to unsecured high yield bonds. CLOs further reduce risk by creating various leveraged loan portfolios (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 to mitigate risk. For example, coverage testing is a key mechanism to detect and correct collateral deterioration, which directly affects cash flow allocation. All CLOs have covenants that require the manager to test the portfolio’s ability to cover its interest payments on a monthly basis. Of the many such tests, the most common are interest coverage and overcollateralization tests. Interest coverage dictates that the income generated by the underlying pool of loans must exceed the interest due on the outstanding debt in the CLO, while overcollateralisation requires that the principal amount of the underlying pool of loans exceeds the principal amount of the outstanding CLO. slices. As shown below, if the tests fail, cash flows are diverted from the more junior tranches to repay the more senior tranches first, until these failures are corrected.
CLOs are structured to minimize defects
Source: VanEck. This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities mentioned herein.
CLOs are less sensitive to changes in interest rates
In addition to their high risk profiles, CLOs are floating rate instruments, mirroring the underlying floating rate senior loans they hold. This means that they have virtually no price sensitivity to changes in interest rates and coupon payments increase as rates rise. As a result, CLOs have historically outperformed in times of rising rates. In fact, investment grade (IG) CLOs have historically provided a more attractive risk/reward profile compared to other bond domains with a similar rating, such as IG corporate bonds and IG floating rate bonds.
Common misconceptions about CLOs
CLOs fall into the category of structured credit, an asset class that includes secured debt securities that held subprime mortgages, a market segment at the epicenter of the 2008 global financial crisis. As a result, some Investors feel that all structured credit is inherently riskier than more traditional fixed income securities. Historical evidence, however, tells a much different story, especially for CLOs.
CLOs have been tested during two major market crises. During the global financial crisis and the COVID-19 downturn, the asset class ultimately experienced fewer defaults than corporate bonds of the same rating. For example, of the roughly $500 billion in US CLOs issued between 1994 and 2009 and rated by S&P, only 0.88% defaulted. In the highest rated AAA and AA CLO tranches, there were no defaults.
Additionally, an experienced CLO investor can analyze each individual credit within a CLO as well as the structural characteristics of each transaction 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 in-depth experience of the CLO market.
Originally published by VanEck on July 7, 2022.
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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 imply the provision 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, speak as of the date of this communication and are subject to change without notice. Information provided by third party sources is believed to be reliable and has not been independently verified as to its accuracy or completeness and cannot be guaranteed. The information contained herein represents the opinion of the author(s), but not necessarily that of VanEck.
An investment in a Collateralized Loan Obligation (CLO) may be subject to risks which include, but are not limited to, debt securities, replacement of LIBOR, foreign currencies, foreign securities, orientation of investments, securities newly issued, extended settlement, management, derivatives, cash, market, operational, commercial and non-diversified risk transactions. CLOs may also be subject to liquidity, interest rate, floating rate note, credit, call, extension, high yield securities, income, valuation, securities issued by the private sector, covenant lite loans, default of the underlying asset and CLO manager risk, all of which may adversely affect the value of the investment.
Any investment is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that the investment objectives will be achieved and investors may lose money. Diversification does not guarantee a profit or protect against loss in a declining market. Past performance is not indicative of future results.
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