Welcome to our series of memos on CLOs, to help un-mask some of the mystery behind this high performance credit product. Over this series we aim to cover:

1. Overview, History & Underlying Loans

2. Life Cycle & Characteristics

3. Selection & Portfolio Management

4. Performance & Default History

So here we go …

An Overview

A CLO, or Collateralised Loan Obligation, is a portfolio of predominantly leveraged loans that is securitized and managed as a fund. The assets are typically senior secured loans, which benefit from priority of payment over other claimants in the event of a corporate insolvency. Each CLO is structured as a series of tranches (interest-paying bonds), along with a small (usually 10%) portion of equity.

A typical CLO Capital Structure

A history

• CLOs originated in the late 1980s as a way for banks to package up on-balance sheet assets (in this case leveraged loans) & provide investors with access to varying degrees of risk and return to best suit their own investment objectives.

Pre-GFC:

• Commonly known as CLO 1.0, the first vintage of product included high yield bonds, as well as loans, and were the standard CLO structure until the Global Financial Crisis of 2007/8.

2010 onwards:

• After a couple of years of zero issuance, the CLO 2.0 began to be issued and included strengthened credit support (principally for the senior noteholders) and shortened re-investment periods. They also largely eliminating high yield bonds under the Volcker Rule.

• Currently, few CLOs allow for investments into high yield bonds, and those that do generally limit their exposure to 5%-10% of the total portfolio. To compensate for the exposure they have increased levels of subordination to better protect the senior debt tranches.

• Versions 2.0 and 3.0 represent the biggest chunk of the existing market, with about $800 billion in principal outstanding. <1% of the market remains in CLO 1.0 product

Leveraged loans

• Leveraged loans predominantly have the following characteristics:

  • 1st lien / Senior secured lending product

  • Support fast growth, private equity owned corporates

  • Usually BB+ or lower (ie. non-investment grade)

  • Floating rate fixed income product paying a cash margin (yield) above a reference rate (SOFR, SONIA or Euribor)

  • 5–7yr terms but given their seniority tend to get repaid early. In fact any corporate M&A activity with the borrower usually sees a prepayment event occur. Expected maturity is therefore nearer 3 years

  • Generally widely syndicated using a standard (LMA or LSTA loan document). Unlike bonds, the terms & clauses can vary, making loans more difficult to make top-down assumptive comparisons and the need for specialized analysis

  • They are issued by corporates from all sectors, with the overriding feature being sustainable, through-the-cycle positive cashflows, enabling the service & repayment of a levered debt structure

• Look out for our next post on the Life Cycle & Characteristics of CLOs coming soon …