Collateralized Loan Obligation
A collateralized loan oblication (CLO) is a structured security that usually holds syndicated corporate bank loans.
- CLO assets usually include syndicated bank loans
- CLO liabilities are usually broken into multiple equity and debt tranches
- Senior lenders fund most of the balance sheet and receive cashflow first
- mezzanine and equity holders receive the remaining cashflows
- the equity tranche is usually ~10%
- CLOs are commonly used by private equity firms to fund deals
- CLOs typically borrower at 3 Month Libor, while the loans they hold are at 1 month libor
- This creates potential for interest rate curve risk
- The difference between 3 month libor and 1 month libor can impact CLO net margins
- A CLO makes money when the yield it assets is great than that of its liabilities
- The profit flows to the equity tranche
- CLOs may have provisions in place that require the manager to take action if:
- there is insufficient cashflow to pay senior lenders
- there is insufficient coallateralization
- there is insufficient diversification
Key Drivers of CLO Equity Returns
- Prepayment frequency
- Ability for manger to reinvest cashflow "(typically 4 - 7 year period)
- Broad credit market risk pricng
- Spread between interest income and current funding costs (usually LIBOR)
- Loan asset default and recovery rates
- Management Fees
CLO Investors
- Senior tranches are popular with endowments and other regulated institutions
- Equity tranches are are popular replacement for private Equity firms (similar return, less lock up and fewer fees)
- CLOs are typically closely held by private investors
- There are some public entities which invest in CLOs
CLO Performance
- Defaults have been minimal over the full history of CLOs
- Senior tranches have historically performed well - with almost no losses
- Equity tranches have have provided high returns from 10-15+%
CLO Criticisms
- Played a large party in the 2008 Financial Crisis
- Generate too many fees for issues and managers (vs return for investors)
- Deal apreads have reduced over time
- The % of Covenant Lite loans in deals has increased over time