CLOs: How They Work

Laila Kollmorgen, CFA
CLO Tranche Portfolio Manager
Los Angeles

20 September 2019

Collateralized loan obligations (CLOs) are attracting increasing attention as investors broaden their horizons in the search for yield. While CLOs offer above-average returns versus other fixed income strategies, some investors may be intimidated by their complexity. We’re here to help.

What is a CLO?

A CLO is a portfolio of 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 reduced risk compared with its predecessors by eliminating high yield bonds and adhering to the Volcker Rule and other new regulations.

The vast majority of CLOs are called arbitrage CLOs because they aim to profit from the difference between the inflows from payments of interest and principal on the leveraged loans and the outflows of management fees and other costs. The market for arbitrage CLOs is valued at $755 billion globally as of 2 August 2019, with about 85% issued in the US and 15% in Europe, according to Morgan Stanley Research.

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’ attractive income stream and the first of several levels of 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 LIBOR or EURIBOR) and secured by a first or second lien. Leveraged loans are particularly suitable for securitizations because 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.

The size of the leveraged loan market is large and growing, with institutional loans outstanding totaling an estimated $1.2 trillion in the US and €205 billion in Europe.

Who issues and owns CLOs?

CLOs are issued and managed by asset managers. Of the approximately 175 CLO managers worldwide, about 75% are in the US and the remaining 25% are in Europe, according to Morgan Stanley.

Ownership of CLOs varies by tranche. The least risky, senior-most tranches are mainly owned by banks (which need high-quality capital to meet regulatory requirements) and insurance companies (which favor income-producing investments). The equity tranche is the riskiest, 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 an above-average return through income and capital appreciation. CLO tranches are ranked highest to lowest in order of credit quality, asset size, and income stream – and thus lowest to highest in order of riskiness.

Tranches Allocate Assets, Income, and Risk
Typical CLO Tranche Structure

CLO Tranche Structure

Source: Morgan Stanley Research. For illustrative purposes only.

Although leveraged loans themselves are rated below investment grade, most CLO tranches are 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 and subordinated 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 mitigate risk?

All 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 coverage and over-collateralization 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 report, “Seeing Beyond the Complexity: An Introduction to Collateralized Loan Obligations.”

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