What is a Collateralized Loan Obligation (CLO)?

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Definition:

A collateralized loan obligation (CLO) is a sophisticated financial instrument in which investors receive a small portion of the payments from hundreds of business loans.

🤔 Understanding collateralized loan obligations

A collateralized loan obligation (CLO) is a type of loan fund that is created by borrowing money from investors to purchase business loans. The CLO manager buys loans that are made by financial institutions, often to companies that are below investment grade (rated BB+ or lower). These senior secured loans have priority on company cash flow and are often backed by assets and inventory. The loans themselves act as both the collateral and the revenue stream for the investor in the CLO. By bundling these lower-quality bank loans together (called securitization), the risk in the CLO’s portfolio can be repackaged into securities of a different risk level than represented by the underlying loans. Interest payments received by the CLO from these assets are used to pay investors.

Example

Let’s say that the fictional Make Believe Company wants to borrow some money to pay out a dividend. The owner goes to Neighborhood Bank and pledges the company’s revenues against a million-dollar loan. Make Believe Company will repay the million dollars plus $100,000 in interest over the next year. Neighborhood Bank then sells Make Believe Company’s loan to a collateralized loan obligation (CLO) for $1,010,000 — Turning an immediate profit of $10,000. Now, when Make Believe Company makes its payments, Neighborhood Bank must pass that money on to the CLO. The CLO turns around and distributes those payments to its investors.

Takeaway

A collateralized loan obligation (CLO) is like sorting a bag of skittles…

If you only like the red skittles, buying a bag ends with you holding on to a whole lot of flavors you don’t enjoy - maybe trying to find someone to trade with. Perhaps you wish you could buy a bag of only red skittles. If so, you might support a company that buys several bags of the chewy little sugar pills, sorts the candy by color, then repackages the treats into single-color bags. That’s basically what a CLO does. It takes hundreds of somewhat risky loans, sorts out the various pieces of risk, and repackages them into low-risk and high-risk investments.

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How does a collateralized loan obligation work?

There are four stages of the CLO lifecycle, which generally occur over eight to 10 years:

  1. Warehousing
  2. Issuance
  3. Expansion
  4. Repayment

Warehousing

First, the owners of the collateralized loan obligation (CLO) create a structured investment vehicle. It’s basically like establishing a company in the business of buying loans. But, to purchase those loans, they first need to raise some capital.

To get started, the CLO takes out a short-term loan from a warehouse provider. This money is used to purchase an initial suite of loans to create a portfolio. This debt is paid off with money raised during the issuance of the CLO.

Issuance

The CLO then looks to investors to finance the endeavor. They do that by selling what are effectively bonds at a variety of risk levels (called tranches), with a return on investment commensurate with the risk. Insurance companies, large banks, and pension funds often purchase these securities.

They offer senior-level debt that receives first call on revenues. That financial security would have the least risk and lowest coupon rate. Therefore, it would receive a rating of AAA or AA.

If an investor is looking for a better return and is willing to take a little more risk, they might purchase junior level debt. These securities are subordinate to the senior level debt, meaning they only get paid once the higher level debt is satisfied. These securities might get rated A or BBB.

An even lower tranche is the mezzanine level. These are typically considered high-risk, but generate high-returns when they are paid. However, all debt investors above mezzanine debt investors have priority in payment. These securities might get rated BB or lower.

The CLO might also sell some equity to raise capital. An equity owner has a right to a portion of the profits the CLO eventually earns. Because all debt investors must be paid before there are any profits to distribute to equity owners, this can be considered the riskiest level of investment in the CLO. Typically, hedge funds and venture capital investors are the ones interested in this option.

Expansion period

With the money raised during issuance, the CLO manager expands the portfolio of leveraged loans. Over a set period, the manager actively manages the loan portfolio. They can sell some loans, buy others, and reinvest revenues received from assets in the collection. During this time, investors might be prohibited from requesting their money back (referred to as a non-call period).

Repayment period

After the reinvestment period is over, the CLO manager cannot purchase or sell any more loans. From that point on, revenues from the underlying assets go toward repaying the debt investors. Revenues are distributed down the capital stack, in order of the priority for each tranche.

The AAA tranche gets paid first — meaning they have the lowest risk exposure and the fastest repayment time. In exchange, they receive the lowest return on their investment. Once the AAA tranche is paid, the AA tranche is next. Revenues are distributed in this way (called a cashflow waterfall) until all of the debt investors have been satisfied.

The CLO manager can also sell equity rather than structured debt to raise funds. However, equity is the riskiest of the investment options in the CLO. Of course, it also provides the most potential reward. Equity investors are typically hedge funds, investment banks, and venture capital groups. If there are additional revenues, after paying off all of the debt, those revenues are distributed to the owners of the equity tranche. Once all the underlying assets are expired, the CLO is closed.

What is the difference between a CDO and CLO?

A collateralized debt obligation (CDO) is an asset-backed security made up of a portfolio of debts. They can be made up of residential mortgages, corporate bonds, commercial real estate loans, credit card debt, student loans, or any other form of debt. Sometimes, a CDO can even be made up of other CDOs.

A collateralized loan obligation (CLO) is a specific type of CDO formed primarily from leveraged loans (business loans made to companies with more than average debt). However, the loans that make up the CLO portfolio are typically senior debt and are usually backed by collateral. Since 2014, no unsecured debt or high-yield bonds are included in CLOs.

CLOs did not face the same level of default that other CDOs experienced during the Great Recession and have grown in popularity in the years since. Banks, insurance companies, mutual funds, and pension funds are the primary investors in the CLO market.

What is a CLO security?

A security is a financial instrument that gives the owner a right to payment. In the case of a collateralized loan obligation (CLO), the security provides the owner the right to payments from the CLO.

The CLO issues these securities in tranches, with each level representing a different amount of risk and potential reward. An investor can choose to purchase a security at the risk level they are willing to accept.

The most senior tranche is AAA, which pays a lower return on the investment but receives priority on payments. A junior tranche might be rated BB, which offers a higher coupon rate (the amount of interest the investor expects), but comes with the risk that not enough money will be earned to pay off the senior securities and still make the payment on the junior levels.

What is CLO risk retention?

Collateralized Debt Obligations (CDOs) have been around since the 1980s. But they gained popularity in the 2000s. The most infamous type of CDO is the Mortgage-Backed Security (MBS), which is believed to have contributed significantly to the 2008 financial crisis. A collateralized loan obligation (CLO) is a particular type of CDO that specializes in business loans. Although not connected to the Great Recession, they got wrapped up in the controversy surrounding such vehicles.

Before 2010, it was common practice for mortgage originators to immediately sell their subprime mortgages into the secondary loan market, which then packaged those mortgages with others. The bundle would subsequently be sold as a financial instrument — called an MBS. However, buyers of the MBS had no insight into the risk associated with the underlying assets. And the loan originators retained none of the credit risks once the mortgage was sold.

This situation led to an incentive for the originators to focus on closing loans without due regard for the ability of the applicants to pay them off. Very risky loans were made to people with no income, no job, and no assets –- Then were passed on to investors with little knowledge of that risk.

Within a few years, these loans experienced much higher than expected default rates. Those defaults subsequently caused a failure in the financial system invested in these CDOs. Later, the housing market, which was being propped up by access to easy money, collapsed. The entire global economy felt the ripple effects move through it.

In response, regulators sought to improve the system by removing the disconnect between loan approval and default risk. In Europe, regulators established a “skin in the game” requirement (called risk-retention). Since 2010, a CLO manager must keep at least 5% of the ownership in that loan. The United States passed a similar rule in 2016. However, the law was overturned by the courts in 2018. It cited the fact that the CLO does not issue the loan, but merely purchases it.

However, the United States did pass a sweeping reform of regulatory oversight in 2010 (called the Dodd-Frank Act). Some of the requirements within that law did alter the CLO world. Most notable is that a CLO no longer includes any unsecured assets, whereas previous CLOs often included up to 10% of unsecured debt and high-yield bonds.

How does a CLO make money?

A collateralized loan obligation (CLO) capitalizes on changing the risk profile of a loan to alter the acceptable interest rate associated with it. This difference in interest rates is called a spread, which allows an opportunity for generating profits.

As long as the weighted-average interest rate paid to CLO investors is lower than the risk-weighted interest being received on the loans in the portfolio, the CLO will earn a profit.

Loans within the CLO typically pay between 200 and 500 basis points above the benchmark interest rate. If the loan is 200 basis points above the London Inter-Bank Offered Rate (LIBOR), and LIBOR is 1.5%, the loan would be 3.5%.

The AAA tranche of the CLO might be set at LIBOR plus 100 basis points and make up 65% of the issuance. The AA tranche might be LIBOR plus 175 basis points and represent another 10%. The lower levels will pay higher rates but come with more risk.

In this way, the CLO can be structured to pay out less on its debt than it receives from the underlying loan assets.

How risky is a CLO?

Several built-in protections help mitigate some investor risk, but every investment comes with uncertainty. However, CLOs have performed well over the last few decades. Roughly half of all senior secured business debt is now held in a CLO.

According to Guggenheim Investments, only 38 out of 10,894 CLO tranches have defaulted since 1994. And, none of those defaults occurred after the Great Recession. Of those that defaulted, 84% were rated below A. Of course, past performance does not predict future results.

Part of the reason for the lower default risk in the upper tranches has to do with the performance tests conducted. One such test is called “over-collateralization.” Each tranche has an over-collateralization ratio. For example, if the AAA tranche has a required collateralization rate of 125%, then a $500 million issuance requires $625 million of assets. If the portfolio value falls, cashflows are diverted from lower tranches to purchase more assets.

Additional investor protection can be afforded by setting limits on the types of assets that can be purchased, restricting the concentration of investors in the pool, demanding a certain level of institutional investor participation, and requiring certain levels of diversification within the portfolio.

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The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory.

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