how collateralized loan obligations clos work
a clo is a bundle of loans that are ranked below investment grade they are usually first lien bank loans to businesses that are initially sold to a clo manager and consolidated into bundles of 150 to 250 loans 1 to fund the purchase of new debt the clo manager sells stakes in the clo to outside investors in a structure called tranches with a clo the investor receives scheduled debt payments from the underlying loans assuming most of the risk in the event that borrowers default in exchange for taking on the default risk the investor is offered greater diversity and the potential for higher than average returns a default is when a borrower fails to make payments on a loan or mortgage for an extended period of time each tranche is a piece of the clo the order of the tranches dictates who will be paid out first when the underlying loan payments are made it also dictates the risk associated with each investment since investors who are paid last have a higher risk of default from the underlying loans investors who are paid out first have lower overall risk but they receive smaller interest payments as a result investors who are in later tranches may be paid last but the interest payments are higher to compensate for the risk a clo is an actively managed instrument managers can and do buy and sell individual bank loans in the underlying collateral pool in an effort to score gains and minimize losses in addition most of a clo s debt is backed by high quality collateral making liquidation less likely and making it better equipped to withstand market volatility 2types of clo tranchesthere are two types of tranches debt tranches and equity tranches debt tranches also called mezzanine tranches are treated just like bonds and have credit ratings and coupon payments these debt tranches come first in terms of repayment and there is also a pecking order within the debt tranches equity tranches do not have credit ratings and are paid out after all debt tranches equity tranches are rarely paid a cash flow but do offer ownership in the clo itself in the event of a sale because equity tranche investors usually face higher risks they often receive higher returns than debt tranche investors clos offer higher than average returns because an investor is assuming more risk by buying low rated debt clo structurea clo consists of several debt tranches ranked according to the creditworthiness of the underlying loans the lowest tier is the equity tranche representing ownership of the underlying collateral as the clo enters the repayment phase investors in higher ranked tranches are paid first followed by lower tranches lower ranked tranches have higher risk profiles but also higher potential returns in the lowest tier the equity tranche investors receive any additional cash flow after the debt investors are paid equity tranche investors also have a degree of control over the clo that is not available to debt investors for example they have options to refinance the underlying clo loans or reset the reinvestment period 3clo processhere s an over simplied overview of how clos are created step 1 establish the capital structure the first step to creating a clo is establishing a capital structure meaning the different levels of debt and equity underlying the security a typical clo has several debt tranches and an equity tranche representing ownership of the underlying collateral step 2 seek capital the next step is to raise capital from investors which is used to buy loans underlying the security each investor will contribute to a different loan tranche with riskier tranches offering higher returns 3step 3 choose tranches as investors commit capital they also have the opportunity to choose a tranche that meets their risk and return appetite step 4 purchase loans the clo manager will use the capital from investors to buy loans the clo manager can reinvest loan proceeds to improve the portfolio either by buying additional collateral or selling poorly performing loans at this stage an underwriter analyzes the loan pool and assesses the creditworthiness of the borrowers the underwriter also determines the appropriate structure and size of the clo transaction step 5 create special purpose vehicle most often a special purpose vehicle spv is created to issue the clo securities the spv is usually designed to protect the investors in case of default step 6 pay investors ultimately the clo will begin repaying investors with a spread that has been pre determined for each tranche at the time of closing afterward holders of the equity tranche can call or refinance the loan tranches eventually the clo begins to deleverage as the underlying loans are paid off the clo manager will repay the investors starting with the most senior tranche any remaining proceeds will go to the equity tranche holders step 7 termination the clo transaction may terminate when all of the securities have been repaid or when the underlying loans have been paid off or sold at this point any special purpose vehicles are dissolved and any remaining assets are distributed to the investors benefits of a clothere are a variety of benefits of a clo including but not limited to risks to considerwith those benefits in mind there are also a number of downsides to clos those risks include but aren t limited to risky asset some argue that a clo isn t that risky research conducted by guggenheim investments an asset management firm found that from 1994 to 2013 clos experienced significantly lower default rates than corporate bonds only 0 03 of tranches defaulted from 1994 to 2019 even so they are sophisticated investments and typically only large institutional investors purchase tranches in a clo in other words companies of scale such as insurance companies quickly purchase senior level debt tranches to ensure low risk and steady cash flow mutual funds and etfs normally purchase junior level debt tranches with higher risk and higher interest payments if an individual investor invests in a mutual fund with junior debt tranches that investor takes on the proportional risk of default 1