Collateralized Loan Obligations (CLO's) are a form of securitization where a special purpose vehicle issues debt and equity, and then uses the money it raises to purchase a portfolio of leveraged loans. It then distributes the cash flows from its asset portfolio to investors that hold various slices of its liabilities, taking into account the senioritiy of those liabilities. CLO's are the biggest purchasers of leveraged loans and purchased about 67% of all leveraged loans until 2007 before the market contracted. At the end of 2012 S&P estimated that there were $310 billion CLO's under management.

 

Collateralized Loan Obligations have been around since the 1980's, but the market started growing significantly in the early 2000's when Institutional investors started looking for higher yielding alternative assets to compensate for the low interest rate environment, which made interest rate risk a concern. 

 

One benefit of CLO's to investors is that it provides access to the leveraged loan market while giving investors the option to choose a specific risk/return profile that suits their needs. This can be done through purchasing any of the liability slices in the CLO which range from the lowest Junior equity tranche to the senior most tranche.

 

Features of a CLO

 

Collateralized loan Obligations have four main features or building blocks that help describe them. The features are its assets, liabilities, credit structure and purpose.

 

• Assets of the CLO are the loans it holds in its portfolio, which are mostly leveraged loans, but sometimes investment grade and distressed loans.

• Liabilities are the various slices of the CLO that investors hold, the tranches run from preferred shares to AAA rated senior debt in seniority.

• Credit structure of the CLO describes how cash flow is distributed to the various tranches in the CLO, and can either be a market value or cash flow credit structure.

• Purpose of the CLO defines the type of CLO and how that CLO acquires it assets. The type can be either a Balance sheet or Arbitrage CLO

 

Credit Structure of CLO's:

There are two types of credit structures that are used in CLO's, Market value credit structure and Cash flow credit structure.

 

• The market value credit structure in the CLO is similar to an individuals margin account with a brokerage. In this structure every asset in the CLO's portfolio is assigned an advance rate that limits the amount that can be borrowed against that asset. The advance rates are usually close to 100% but vary according to the market volatility or fluctuations in the asset. More can be borrowed against assets that fluctuate less and vice versa for assets that fluctuate more.  The sum of all the advance rates times the market values of the assets is the total amount that the CLO can borrow. This type of credit structure is not popular with a lot of CLO's and make up a very small portion of all existing CLO's.

 

• The cash flow credit structure is based on the concept of waterfalls, where distibutions in cash flow interest and principal payments across the various tranches are administered according to a waterfall structure based on seniority. There are two waterfalls in the cash flow CLO; one for collateral principal and the other for interest. The cashflow waterfalls determine the order in which CLO creditors get paid in the order of seniority. Buried within the waterfalls are coverage tests which are carried out in certain slices of the CLO to ensure that cash flow needs are met. If certain senior slices fail a coverage test, the waterfall directs cash from subordinated creditors and redirects it to senior creditors until coverage tests are met.  The CLO sizes subordination of assets in the CLO so that cash flow from assets that default can be used to cover debt tranche principle and interest with a degree of certainty.

 

Types of Collateralized Loan Obligations 

 

• Balance Sheet CLO's, these CLO's are created for the purpose of securitizing certain assets and removing them from balance sheets of banks to reduce regulatory capital requirements.

• Arbitrage CLO's are created to take advantage of additional income from the pool of loans over the CLO’s cost of financing (i.e., average coupon of the issued debt tranches).

 

Reasons why CLO's appeal to investors

 

CLO's are appealing to investors because they provide access to the floating rate nature of leveraged loans and their senior security in the corporate capital structure.

They also provide investors acces to the leveraged loan market without the administrative burden of  loan settlements