Updated Feb 24, 2022
What is Collateralized Loan Obligation (CLO)?
What is a Collateralized Loan Obligation (CLO)?
Investors frequently buy and sell firm debt in the financial sector. Lenders can reduce their risk and investors can increase their rewards by using a collateralized loan obligation. In this post, we'll define collateralized loan obligations, explain how they function, look at how to build one, and discuss some of the benefits they offer to investors.
What is a collateralized loan obligation?
Collateralized loan obligations, also known as CLOs, are securities or marketable financial assets backed by a pool of loans. Simply put, they're repackaged debt that's been offered to investors, as well as a sort of collateralized debt obligation. CLOs are comparable to collateralized mortgage obligations, or CMOs, except their underlying debt, is corporate loans rather than mortgages.
Corporate loans with leveraged buyouts from equity firms to gain a controlling interest in a company or low credit ratings make up the majority of the pool of loans associated with collateralized loan obligations. Payments from several business loans are pooled together and then transferred to many classes of owners in different tranches in a collateralized loan obligation. The investor assumes the debt and receives the loan payments while also taking on the risks of borrower default or failure to make debt payments for an extended period. Those who are willing to accept this risk may be rewarded with higher returns and greater diversification.
Loan markets cannot function without CLOs. Many people feel that collateralized loan obligations, despite their nature, pose little risk. Corporate bonds, for example, have a greater rate of default than collateralized loan obligations. CLOs, on the other hand, are more sophisticated assets that are typically only purchased by large institutions like insurance companies and mutual funds.
In a collateralized loan obligation, insurance firms typically buy high-level tranches to provide a consistent cash flow with minimum risk. On the other hand, ETFs and mutual funds often invest in mid-level debt tranches with greater interest payments and a larger chance of default. CLO managers, on the other hand, are the most active purchasers of collateralized loan obligations.
How does a collateralized loan obligation function?
When a loan, usually a first-lien loan from a bank to a business, is deemed unsuitable for investment, it is sold to a collateralized loan obligation management. The loan manager bundles loans together after purchasing them. Between 100 and 225 loans are usually included in this bundle. Once the loans have been bundled, the loan manager consolidates them by purchasing and selling loans regularly.
The collateralized loan manager raises money for additional debt acquisitions by selling interests in the collateralized loan obligation to outside investors through a structure called tranches. Every tranche in this structure reflects a chunk of the collateralized loan obligations, determining which investors will be paid first when the underlying loan installments are made.
Because the investors that receive payment last are at a larger risk of the borrower defaulting on the underlying loan, the tranche structure also symbolizes the level of risk associated with each investment. The interest payments on these tranches are higher to compensate for the investment's risk. On the other hand, the investors that are paid first have a smaller overall risk. However, as a result, the interest payments are significantly reduced.
The syndication procedure is used by collateralized loan obligation managers to purchase loans. Here's an example that express its working:
- A corporation seeks a $50 million loan from a bank to expand its operations. The bank approves the $50 million loan, but they then break it up into smaller portions and begin seeking more lenders to help pay the $50 million. This significantly decreases the bank's risk by forming a syndicate. The loans are subsequently purchased from the bank by lenders such as the collateralized loan obligation management.
What are tranches and how do they work?
Tranches are divided into two categories:
Tranches of debt:
These tranches are treated as though they were bonds. They are frequently the first to be returned because they have coupon payments and credit ratings.
Tranches of equity:
The equity tranches are paid after the debt tranches, and there are no credit ratings on them. If the CLO is sold, these tranches offer ownership of the collateralized loan obligation. They are, however, rarely paid in cash.
Based on the investor's needs and wants, they can purchase any level of tranche that meets their return and risk expectations. The lower the return and risk, the higher the tranche's rating. They do, however, receive payment initially. The debt tranches are at the top of the tranche structure, while the equity tranches are at the bottom.
The equity tranches are by far the riskiest, but also the most profitable. For example, if a borrower is a collateralized loan obligation fails to make payments, or defaults, the investors who own the lowest tranches will be the first to incur losses.
How do you make a collateralized loan obligation?
To create a collateralized loan obligation, follow these simple steps:
- The loan manager creates a capital structure with different return and risk probabilities for each tranche.
- The loan manager seeks out and secures the necessary funds from a variety of sources.
- After reviewing the return and risk probability, the investors are invited to choose a tranche with which they are most comfortable.
- With the funds rising from the investors, the loan manager purchases loans.
- Starting with the top tranche, investors are paid using the interest generated by the loans.
Benefits of collateralized loan obligations
Investors can benefit from collateralized loan commitments in the following ways:
Over a long period, collateralized loan obligation tranches outperform other types of corporate debt, such as investment and non-investment-grade bonds and bank loans.
Because they feature adjustable-rate loans, collateralized loan obligations can be utilized as an inflation hedge.
The collateralized loan obligations are actively monitored and managed by a loan manager, or numerous loan managers in some cases. Their payment is usually contingent on the CLO's success.
Loans with a variable interest rate:
The underlying loans in a collateralized loan obligation have fluctuating rates, resulting in a shorter term. As a result, interest rate swings put the collateralized loan commitments at risk.
Over-collateralization means that even if a few loans default, the higher-ranking tranches are unaffected. The lower tranches of collateralized loan obligations are impacted first.
What's the Difference Between a Collateralized Loan Obligation (CLO) and a Collateralized Mortgage Obligation (CMO)?
CLOs and Collateralized Mortgage Obligations (CMOs) are similar in that they are both based on a vast portfolio of underlying financial instruments. The fundamental distinction between the two is that CLOs are based on corporate debts, whilst CMOs are based on mortgage loans. Credit derivatives include both CLOs and CMOs.
CLOs are complicated investments that aren't fit for everyone. CLO investors often receive payments that are split between interest and principal repayment. These installments may differ depending on the rate at which the loans are repaid. Some CLOs may have structures that make it difficult to forecast how they will react to interest rates and other circumstances, making their prices volatile, and exposing them to liquidity and valuation risk.