Understanding Collateralized Loan Obligations (CLOs)

Summary

Collateralized loan obligations (CLOs) are typically a high yielding, scalable, floating-rate investment alternative to corporate bonds with a history of stable credit performance. CLOs represent a $970 billion asset class within the broader $12 trillion structured credit fixed-income market, which also includes asset-backed securities (ABS). CLOs derive principal and interest from an actively managed, diversified pool of non-investment grade, senior-secured corporate loans.

These loans, also known as bank loans or leveraged loans, typically occupy a first-lien position in the company’s capital structure, are secured by the company’s assets, and rank first in priority of payment ahead of unsecured debt in the event of bankruptcy.

The combination of diversified, actively managed, senior-secured loan collateral along with sound securitization structures has resulted in favorable historical ratings performance. CLOs’ historically low default rate across the ratings spectrum compares favorably to corporate debt.

Investing in CLOs is not without risk. As with other securities, CLOs are subject to credit, liquidity, and mark-to-market risk, and the basic architecture of CLOs requires that investors must understand the waterfall mechanisms and protections as well as the terms, conditions, and credit profile of the underlying loan collateral.

However, CLOs have several features that make them an integral component of Guggenheim’s fixed-income strategies. One of the most important characteristics of CLOs is their floating-rate coupon, which helps insulate bond prices from volatile interest rates.

Report Highlights

• Collateralized Loan Obligations (CLOs) represent a high yielding, scalable, floating-rate investment alternative with a history of stable credit performance.
• Credit performance through the Great Financial Crisis (GFC) and COVID-19 risk cycles has supported growth in the CLO market, broadened the investor base, and supported secondary market liquidity.
• Guggenheim Investments’ long-term experience mobilizing credit research, structural analysis, analytic infrastructure, and legal expertise in service of our investment process positions us to capture the attractive relative and fundamental value in CLOs though a cycle.

Overview: What Are CLOs?

CLOs are a $970 billion asset class within the broader $12 trillion structured credit fixed-income market¹, which also includes asset-backed securities (ABS). CLOs derive principal and interest from an actively managed, diversified pool of non-investment grade, senior-secured corporate loans.

CLOs use funds received from the issuance of debt and equity to investors to acquire a diverse portfolio of typically more than 200 loans. The debt issued by CLOs consists of a variety of tranches, each with a risk/return profile based on its seniority and claim priority on the cash flows produced by the underlying loan pool.

These loans, also known as “bank loans” or “leveraged loans,” typically occupy a first-lien position in the company’s capital structure, are secured by the company’s assets, and rank first in priority of payment ahead of unsecured debt in the event of bankruptcy. Economically, the CLO equity investor is the owner of the pool of loans and the CLO debt investors provide term financing to acquire the pool of loans.

Understanding CLO Collateral: Leveraged Loans

A portfolio of loans act as the collateral supporting a CLO. The proceeds of these loans are typically used by non-investment grade borrowers to support a range of activities, including mergers and acquisitions, stock repurchases, dividend payments, leveraged buyouts, or investment in new projects. Loans are provided by a group or “syndicate” of institutional lenders and arranged by an investment bank. Most CLO collateral consists of senior secured loans, or first-lien loans, which have a priority claim on all of the related company’s assets in the event of a bankruptcy and are intended to be a less risky investment in these companies. Loans carry floating-rate coupons typically benchmarked to the Secured Overnight Financing Rate (SOFR). Loans carry a number of covenants, including financial covenants that may restrict lender-unfriendly actions, and require compliance with certain credit metrics. The senior secured position of these loans has contributed to higher historical recoveries in default scenarios than those seen in the high-yield bond market.

Understanding CLO Structures

At its inception, a CLO raises money to purchase a portfolio of loans by selling various debt and equity tranches to investors. Each tranche has a different claim priority on the cash received from the loan pool and exposure to loss from the underlying collateral pool. Cash flow distributions begin with the senior-most debt tranches of the CLO capital structure and flow down to the junior-most equity tranche—a distribution methodology that is referred to as a waterfall. The cash flow waterfall and a suite of performance tests and collateral concentration limits provide varying degrees of protection to the CLO’s debt tranches.

The CLO’s most senior and highest-rated AAA tranche carries the lowest coupon but is entitled to the highest claim on the cash flow distributions and is the most loss-remote. Mezzanine tranches pay higher coupons but are more exposed to loss and have lower ratings. The most junior and riskiest part of the CLO capital structure is the equity tranche, which is neither rated nor coupon bearing. Instead, the equity tranche represents a claim on all excess cash flows that remain once the obligations for all debt tranches have been met. AAA senior tranches are the largest and typically represent 70 percent of the capital structure. Mezzanine AA to BB-rated tranches are much smaller and typically represent 4–12 percent of the capital structure each. Equity tranches vary in size but are typically about 8–10 percent of the capital structure.

CLOs are governed by a series of coverage tests to measure the adequacy of the collateral balance and of cash flows generated by the underlying bank loan collateral. One such test is an overcollateralization test (OC test), which ensures the principal value of the bank loan collateral pool exceeds the outstanding principal of the CLO debt tranches. If the bank loan collateral’s principal value declines below the OC test trigger value, cash that otherwise would have been distributed to the equity and junior CLO tranches will be used to instead pay down senior debt tranche investors. Another test computes interest coverage (IC test), which ensures the adequacy of cash collected from the bank loan collateral to pay CLO tranche interest. If collateral collections decline below the IC test trigger value, cash that otherwise would have been distributed to the equity and junior CLO tranches will be used instead to pay down senior debt tranche investors, in a manner similar to the OC test described earlier.

CLOs are also subject to a variety of collateral concentration limits that seek to limit risk in the bank loan collateral pool and protect CLO investors from loss. Examples of these limits include requirements for industry diversification in the underlying pool of bank loans and exposure to non-senior secured loans and single obligors. There are also limitations on the balance of CCC-rated loans that can be included in the underlying collateral pool, which helps contain overall default risk.

Most CLO portfolios are actively managed. The collateral manager seeks to mitigate losses from loan defaults and optimize the bank loan portfolio’s value through actively managing the holdings and positioning of the portfolio over a predefined reinvestment period. CLOs do not have mark-to-market tests and are only dependent upon cash flow performance (e.g., timely payment of principal and interest), ratings, maturities, and defaults of the underlying bank loans. Therefore, CLO managers are not forced sellers during periods of market volatility, and can buy and sell bank loans to take advantage of opportunities in the market to find value or minimize losses on deteriorating credits.

Historical Performance

The combination of diversified, actively managed, senior-secured loan collateral along with sound securitization structures has resulted in favorable historical ratings performance. According to Standard & Poor’s, CLO 1.0s (CLOs that were issued before the GFC) exhibited strong credit performance during the financial crisis and produced a very small number of lifetime defaults. CLO 2.0s (CLOs issued after the GFC) feature numerous additional credit improvements compared to their pre-crisis counterparts.

First, rating agencies now require that CLOs carry substantially more overcollateralization than their pre-crisis counterparts. Second, whereas pre-crisis CLOs were able to make meaningful investments in subordinated bonds and other structured credit instruments, post-crisis CLOs are collateralized almost exclusively by senior secured bank loans. Third, post-crisis CLOs’ documentation is much more investor friendly, for example, by shortening the trading period during which the manager is able to actively manage the loan portfolio, and limiting extension risk for CLO securities. Due to their enhanced collateral and structural improvements, CLO 2.0s experienced even better performance than CLO 1.0.

CLOs’ historically low default rate across the ratings spectrum compares favorably to corporate debt.

Secondary trading volumes in investment-grade CLO tranches have been fairly stable year over year, and underscore the ability of risk to change hands even in challenging market environments. The buy-and-hold oriented sponsorship of investment-grade CLO tranches can be observed in the lower level of turnover. In contrast, non investment-grade CLO tranche trading volumes are higher and more variable, highlighting their more opportunistic and risk-tolerant buyer base.

Investing in CLOs

CLOs have several features that make them an integral component of Guggenheim’s fixed-income strategies. In addition to their investor-friendly structural protections and historical credit performance, one of the most important characteristics of CLOs is their floating-rate coupon, which helps insulate bond prices from volatile interest rates. Fixed-rate securities decline in value as interest rates rise and investors discount the value of the fixed-rate bonds’ relatively low coupons. However, the coupons on floating-rate securities such as CLOs adjust based on the current short-term interest-rate environment. As a result, floating-rate securities’ prices tend to be more stable in volatile interest-rate environments than those of their fixed-rate counterparts.

Investing in CLOs is not without risk. As with other securities, CLOs are subject to credit, liquidity, and mark-to-market risk, and the basic architecture of CLOs requires that investors must understand the waterfall mechanisms and protections as well as the terms, conditions, and credit profile of the underlying loan collateral. Thus, the relative value determination for a CLO simultaneously considers potential returns relative to other securitized and corporate fixed-income sectors as well as its pricing relative to other short-duration options.

Capturing opportunities in the CLO market requires the expertise to perform bottom-up research on individual bank loans in the underlying collateral pool. Because CLOs routinely have over 200 issuers in their collateral pools, investment managers must have significant corporate credit research capabilities to fully evaluate the underlying credit risk in each CLO.

The importance of understanding a CLO’s structural characteristics cannot be underestimated. Two CLOs with the identical collateral assets may perform differently due to structural differences. The legal documentation that governs a typical CLO can be in excess of 300 pages, and a high degree of expertise and consistent market presence are required to analyze these documents and discuss key terms with managers looking to access the market. The ability to access the value in CLOs becomes available to investors with the appropriate mix of credit research, structuring experience, and legal expertise.

The Guggenheim Approach

Guggenheim’s approach to investing in CLOs is consistent with our process for all our fixed-income investments. With CLOs, the Guggenheim investment process starts with a bottom-up fundamental approach to CLO structures. Guggenheim brings to bear its extensive research insights across a broad spectrum of the bank loan market and the structuring and legal expertise necessary to understand the nuances of each individual CLO investment opportunity. Collateral, structure, and manager attributes are evaluated, and stress testing and scenario analyses are performed. Research is augmented by our in-house legal team and by the obligor-level credit views of our corporate credit team. Investments are integrated into portfolio strategies by considering relative value, risk, and sector targets, as well as the risk-adjusted return potential evaluated from a long-term holding period point of view.