CLO bonds

1.- Introduction.

2.- What are the CLOs?

3.- How do they work?

• Who issues them?
• How are they issued?
• CLO trenches.
• What do these cash flows mean?
• Who rates them?

4.- CLOs advantages and risks.

• Benefits.
• Risks.
• How to reduce the CLOs risk?

5.- Conclusions.

1. Introduction.

In this article, we will deal explain what CLOs are. A form of securitization based on leveraged loans. Due to the risk inherent in such loans, the benefits they provide are considerably relevant. They are therefore undoubtedly key players in today’s financial markets. In this article we will therefore explain what their risks are. But we will also explain why they enjoy high returns and wide margins.

Nowadays, we see how in the USA and Europe, debts with a high risk of default have become the most important ones. At first, due to their great boom, which has been increasing throughout the years following the 2008 crisis. Today, due to the uncertainty generated by the CoVid-19. Now, they wait with uncertainty for the future of the events that could provoke the current health crisis. They are based on leveraged loans, which logically depend on the situation of the borrowers. Borrowers who are undoubtedly being affected by the CoVid-19 crisis.

Therefore, in ILP Abogados we consider necessary to make a brief analysis to check what this type of bonds are. But as a preview, we have mentioned that they are a form of securitization. In this respect, we recommend the article on securitizations. It serves as a basis for a more accurate understanding of the terms explained below.

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2.  What are the CLOs?

As the article goes on, we will explain this type of bond in order to obtain a complete overview. Let us begin by defining this type of bond and its characteristics.

By their name, collateralized loan obligation. They are debt securities, whose collateral is a leveraged loan. That is, they are guaranteed by loans, generally granted to companies, although personal loans may also be given, etc. Thus, the investor who buys a CLO will bear the risk inherent in the collateral. This is because they are derived from CDOs. That is, from collateralized debt obligations, in this case guaranteed by loans, which we will explain below.

We have previously mentioned debts with a high risk of non-payment. And this refers to the assets that support CLOs: leveraged loans. This type of loan can be extended to both companies and individuals. As long as they have significant amounts of debt, or a negative credit history. Thus, these loans have a high risk of default and are more expensive for the borrowers involved. Therefore, interest rates will be higher.

In addition, it is important to note that these leveraged loans are generally securitized (as is the case here). Because of this situation, they are now issued with much less restrictive covenants, called “covenant-lite loans”. Covenants, in short, are clauses in loan contracts that guarantee the lender the return of its credit. They therefore oblige the debtor to act in a financially prudent manner. What we are saying when we mention covenant-lite loans is that they are not as restrictive as they could be. If you would like more information on this subject, we recommend the following publication: “Covenant and Waivers, What Are They?”

The above explains the high percentage of profits involved in this type of bond. As well as the risk inherent in them. In this type of bond, the investor will receive constant payments derived from the collateral loans. In return they will assume the risk in case the borrowers default. So the investor is offered a great deal of diversity and potentially higher returns than usual.

3. How do CLOs work?

Leveraged loans are generally rated below investment grade. Therefore, they are high risk, although they offer high returns and benefits in return, as we have seen.

The lender (usually, but not necessarily, a bank) wants to obtain liquidity. These leveraged loans, whose monthly payment is made by the borrowers, do not provide it. Therefore, the entity sells them to a “CLO manager”, usually investment funds.

• Who issues these CLOs?

These managers, usually Investment Funds, group these leveraged loans into lots (usually ranging from 100 to 225). Thus, with the sale of these loans, this fund buys new collateral for its successive sale. These managers must have the appropriate infrastructure. That is, professionals specialized in these operations, as well as managers of the aforementioned portfolios. The task of these managers is vital. They are responsible for the decisions made regarding these CLO bond portfolios. Therefore, if they do a good job, the performance of these bonds usually improves.

• How are they issued?

They are issued for investment in so-called “tranches”. Each tranche is part of the CLO, and its rating involves a series of relevant data:

• • The time at which each one is going to be paid out. In other words, the best rated tranches will be the first to be paid. Therefore, the investors who invest in these will be recovering their investment first.
  • They determine, logically, the risk inherent in them. Thus, a better tranche rating implies a lower risk of these loans. Therefore, they are less likely to be defaulted on.
  • Logically, the higher the risk, the higher the return, and the lower the risk, the lower the return. Therefore, the tranches that are paid first are those that have the least benefit, due to their greater security. And those who are paid last, in exchange for the risk they bear, charge more.

• What are these tranches?

Usually, there are two types of tranches within CLO bonds: Debt tranches and equity tranches.

• • Debt tranches are those that are rated from “AAA” to “BB”. They guarantee greater security than the equity range, even though it decreases as we move down from the “AAA” range.
  • Equity tranches, in which the investor will be charged last, although as we know, the benefits will be greater. This is because they have taken considerable risk.

One additional piece of information is worth noting. We mentioned earlier that normally, leveraged loans are rated below investment grade. However, generally, most tranches in CLOs are rated investment grade. This is because they benefit from diversification, credit insurance, and subordinated cash flows, among others.

• What do these cash flows mean?

They are the veins of the CLOs, since they determine the distribution of benefits and the principal. We have seen that the best rated tranches are paid earlier. Thus, they will be paid in sequence or cascade. Starting with the senior tranches and ending with the subordinate ones. This, until the corresponding amounts have been distributed. Therefore, the equity tranche absorbs the costs and receives the residual payment, once the expenses have been paid.

• Who rates these tranches?

Rating agencies. Without prejudice to the detailed explanation in the aforementioned article on securitization. These agencies certify the quality of the loan-backed tranches in which the investment is to be made. Their purpose is therefore to add value to something that already reflects the market price of the CLOs themselves. In this way they try to give stability to the financial market. It is therefore necessary to point out that at present, the ratings given have been significantly reduced. This is due to he global health crisis we are experiencing. In other words, there is a tendency to give worse ratings to CLOs. This is due to the loss of income of the companies and the corresponding loss of solvency. In view of this situation, rating agencies have been forced to re-evaluate the risks faced by investors in CLOs.

4. CLOs benefits and risks.

Let’s look at the benefits and risks that can arise from investing in CLOs.

a) Benefits

• • In the long term, investing in CLO provides great benefits. More than ther types of financial products. Therefore, they have a high performance. Thus, this performance has even higher margins, reflexing the complexity of these CLOs. They also have an attractive risk profile. Therefore, they are less risky than other securitization products.
  • Due to the european regulation, the manager must own 5% of the assets value. Therefore, they also have interest in these investments to success.
  • Due to the leveraged loans that guarantee them, and the fact that they are secured by first lien guarantees. The quality of these loans is stronger.
  • They also have lower sensibility to the interest rates. Which means their prices are maintained although the interests rise or decrease.

Therefore, as we can see, the list of benefits is considerable. But CLOs also carry a number of detriments or risks. We break them down:

b) Risks

• • Credit risk. As mentioned above, CLOs have a first lien guarantee in case of default on these leveraged loans. However, the inherent risk involved in these loans is noteworthy, as we have been saying. This is because they are based on debts with a high risk of default.
  • CLO bond managers and their role. When they perform well, the CLOs do too. This means that when they do not perform well, the CLOs are harmed. So it is important to have an experienced and proactive manager.
  • If the loans securing these CLOs are prepaid, it would dislocate and interrupt cash flows. Also, if these mentioned loans fail, investors will naturally suffer. As we know, due to this cascade payment, the equity investors will be the first to suffer. Therefore, they always bear the greatest risk.

c) How can the CLOs risk be reduced?

Among other methods, we must focus on the figure of the CLO Manager. When a CLO portfolio is created, the figure of the above-mentioned manager is vital. This way, he can actively manage the portfolio, making movements with the leveraged loans included. Therefore, he can try to obtain benefits and reduce risks with his decisions.

5. Conclusions.

As we can see, the boom surrounding this securitization product called CLO is logical. We have explained why CLOs offer a wide profit margin. Relying on leveraged loans provides, in addition to those benefits, some risks inherent in them. Each agent participating in the securitization is vitally important to the performance of the CLOs. It is therefore important to highlight the figure of the “CLO manager”. His actions will mark the increase in profits or losses that a CLO portfolio may experience.

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