CLEO or collateralized loan obligations are types of securities that pool the payments from multiple business loans and distribute them to different classes of investors. These securities have the characteristics of a bank loan and are a form of securitization. This makes them an ideal vehicle for lending money to small businesses. However, there are some important points to consider when investing in a CLO.
Cash flows are distributed based on a “waterfall”:
A CLEO is a structured investment that uses cash flows from the underlying loan portfolio to pay interest to the debt tranches. The distribution of these cash flows takes place in a waterfall fashion, with the most senior tranche receiving a larger share of the proceeds. This waterfall pattern distributes principal and income in a sequential manner, with equity-tranche holders receiving residual distributions after costs are deducted.
A CLO is funded by a series of layers of debt and equity. The debt obligations are senior to one another in the CLO cash flow waterfall, with the most senior tranche receiving the first payments. This pattern is repeated all the way down to the lowest CLO equity tranche. This waterfall also has a reverse waterfall principle, with the lowest tranche receiving most of the interest income from the senior secured loan portfolio.
Loans are paid down in order of seniority:
The CLO structure consists of two parts: a pool of assets and collateral, and individual loans, known as tranches. Each tranche is paid down in order of seniority, so the most senior tranches are paid down first. Subsequent tranches will be paid down in reverse order of seniority.
A CLO’s loan portfolio is actively managed by a collateral manager. This includes monitoring the loan portfolio and paying down principal repayments. The loan portfolio is actively managed during the reinvestment period, which lasts for about four to five years. During this time, principal repayments are reinvested by the collateral manager into new assets.
Securities are rated notes and unrated equity:
CLOs are portfolios of leveraged loans pooled together and sold to investors as a whole. These portfolios include both rated notes and unrated equity, which are referred to as “tranches.” The securities are actively managed by a third-party asset manager. The rated debt tranches receive principal payments while the unrated equity tranches receive residual cash flows. The CLO investors are typically financial institutions and insurance companies.
During a downturn, trading CLO portfolios is challenging, since investors must contend with downgrades and depressed loan prices. Nevertheless, CLOs are an important part of the financial system and will probably remain in existence for several decades. There are many ways to improve the CLO market and make it more reliable.
Warehouse investors earn the carry:
There are two major ways to earn the carry from warehouse investors. In the first way, they earn the carry when the CLO is sold for more than it is worth. This is referred to as mark-to-market financing. In this type of financing, a special purpose entity will issue securities in exchange for the warehouse lender’s loan. These securities will be used to pay the warehouse lenders and the underwriting bank.
Another method is by investing in a CLO with a warehouse manager. A warehouse manager will begin acquiring assets several months before the CLO is launched, and it is during this period that warehouse investors earn the carry. This approach gives them the opportunity to invest in the equity of the CLO at economics not available in the secondary market.
Leverage affects CLOs:
There are a variety of different ways that leverage affects CLOs. For example, a CLO may buy a loan at 96 cents on the dollar, then reinvest the proceeds into a new loan at a discount of 4% to 5%. Although this may not seem like a significant jump, when multiplied by the hundreds of loans in a CLO, the effect can be significant.
In addition, CLOs are susceptible to idiosyncratic shocks. These shocks can make several CLOs sell off certain kinds of loans simultaneously to ease their leverage constraints. These “fire sales” can depress the liquidity of the market, reduce the prices of underlying loans, and hurt the capital of other loan investors.
Volcker Rule affects CLOs:
The Volcker Rule is changing the way CLOs are structured and traded. While the initial intention of the rule was to exempt CLOs from the new rules, the changes could disrupt the CLO market. Some CLO managers may be forced to sell securities from the pool that serve as their collateral. In other cases, banks may have to sell triple-A tranches and equity.
While banks technically do not own triple-A tranches, they do lend to them. As a result, the Volcker Rule’s definition of ownership includes the right to remove the investment advisor. This could affect the ownership interests of investors in CLOs. Fortunately, most CLOs still allow triple-A investors to retain certain rights, including the right to change managers.