Loren Sageser, Credit Strategist: A CLO is a securitized vehicle which borrows money from debt and equity investors to invest in a portfolio of floating rate corporate bank loans, and the portfolio is actively managed by a professional investment manager.
CLOs have been around since the mid-1990s and provide investors with an opportunity to take advantage of complexity and illiquidity premia.
Chart: The chart is a graphical representation of how a CLO works. One bar depicts assets (portfolio of bank loans) with declining cash flows. The second bar depicts liability tranches with realized losses from bank loans increasing.
When a CLO is newly issued, the money for the portfolio of bank loans is raised from debt and equity investors, and the debt is divided into a series of different levels, which we call tranches, from AAA, AA, single A, on down to BB or even single B.
The proceeds of the debt and equity issuance is used to purchase a portfolio of bank loans, and as that portfolio of floating rate bank loans generates coupon income, that income is taken on a quarterly basis and used to service the debt in order of priority. So the AAA investors get paid first, AA, single, on down. The residual, after fees and expenses of the vehicle, is paid out to equity investors as sort of a dividend, which is paid on a quarterly basis.
To the extent that there are losses in the bank loan portfolio, it works the opposite direction. The losses will hit the equity investment tranche first and move up from there. And it’s important to point out too that losses are measured on a realized basis. So to the extent that there are market value changes in the portfolio, the CLO, in many cases, really just tends to ignore that.
So, for the equity investor in a CLO, it’s sort of an arbitrage in the sense that on the day a CLO is issued, the debt spreads are effectively fixed for the life of the CLO.
Chart: The chart depicts a CLO equity arbitrage from portfolio income, cost of CLO debt, CLO fees, residual to equity and then the full equity tranche.
And as the portfolio generates coupon income, that’s used to service the debt. Now, to the extent that bank loan spreads increase, that portfolio of coupon income can increase as well. Since the debt costs are fixed, this can increase the amount that’s paid out to equity investors.
To the extent that the portfolio manager who is managing the bank loan portfolio is avoiding default and hopefully avoiding realized losses as well, a lot of those benefits of increasing spreads can actually flow through to the equity investors.
Chart: The bar chart (IRR) has a line graph overlay (year-end bank loan spreads) and looks at how CLO equity changes relative to widening bank spreads on an annual basis from 2003 to 2012.
And this is what we saw during the financial crisis and immediately after it, was that a lot of the CLOs that had been issued immediately before the financial crisis actually had very, very cheap borrowing costs. So as spreads subsequently widened over 2008, 2009, and stayed fairly wide in 2010, 2011, this actually increased the excess spread that was paid out to equity investors in the CLOs.
CLOs tend to get a bad rap from many investors because they are associated with the CDOs that were issued immediately before the financial crisis, many of which invested in residential mortgages or commercial mortgages or ABS, which actually didn’t do very well.
CLOs, by contrast, even though they were certainly marked down, and market values for CLOs fell, for investors who held on to those investments, they actually performed quite well.
So where we sit today, for many investors who look at credit spreads and may think that they are fully valued, now might actually not be a bad time to invest in CLOs or, in particular, CLO equity.
CLOs also generate fairly attractive income on a quarterly basis, so for investors who are perhaps waiting for a widening in credit spreads in the future, in many cases, they may be getting paid to wait.
Text on screen: Potential Risks of Investing in CLOs
- Credit risk, including default
- Prepayment risk
- Market volatility
- Manager risk
- Deterioration of collateral
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