Terms

CLO

A collateralized loan oblication (CLO) is a structured security that usually holds syndicated corporate bank loans.

More About Collateralized Loan Obligation

Collateralized Loan Obligation Basics
  • 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
  • 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
    • OXLC (Oxford Lane Capital Corp)
    • ECC (Eagle Point Credit Co)

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