A Guide to Collateralized Loan Obligations (CLOs) (2024)

This article was originally published on ETFTrends.com.

By William Sokol, Director of Product Management

What Is a Collateralized Loan Obligation (CLO)?

Acollateralized loan obligation (CLO)is a portfolio of predominantly senior secured loans that is securitized and actively managed. Each CLO issues a series of floating rate bonds, along with a first-loss equity tranche. The tranches differ in terms of subordination and priority—and, thus, lowest to highest in order of riskiness. Major rating agencies, such as Moody’s and S&P Global Ratings, provide ratings on the investment risk of these individual tranches as they do within other areas of fixedincome.

Cash flows from the underlying loans of a CLO are used to pay interest on the debt tranches, and get distributed based on a “waterfall” whereby cashflows are paid sequentially starting with the senior-most tranche until each tranche has been paid its full distribution. Equity-tranche holders receive the residual distributions, net of costs. Principal distributions are similarly applied first to the most seniortranches.

How CLOs AreStructured

CLOs issue multiple tranches of debt to finance the purchase of the underlying leveraged loans. The debt tranches typically account for about 90% of total CLO liabilities, which combined with approximately 10% of equity comprise the entire capital structure. The tranches are ranked highest to lowest in order of credit quality and priority to receive cashflows (both principal and interest)—and, thus, lowest to highest in order ofriskiness.

Although leveraged loans themselves are rated below investment grade, most tranches are rated investment grade, benefiting from diversification, credit enhancements, and priority of cashflows.

CLOs are actively managed vehicles. In a typical CLO structure, there is areinvestment period(typically the first 5 years after the CLO is issued) during which the manager can buy and sell loans within the portfolio and reinvest within the parameters set forth by the governing documents. Managers can add value by reinvesting and positioning portfolios to increase returns in benign economic environments and protect against downside risk during weaker economictimes.

A Guide to Collateralized Loan Obligations (CLOs) (1)

Source: PineBridge Investments.This is not an offer to buy or sell, or recommendation to buy or sell any of the securities mentionedherein.

Who Manages CLOs?

CLOs are generally issued and managed by asset managers that specialize in credit, and the CLO investor base is largely institutional, with banks, insurance companies and hedge funds often purchasing CLOs directly or through institutional separate accounts. Recently, however, the launch of CLO focused ETFs has opened up the market to all types ofinvestors.

Assessing a CLO manager is one of the most critical steps of CLO tranche investing. CLO managers have their own unique investment process and style, resulting in different portfolios and risk/return characteristics. Accordingly, performance may vary greatly among managers, and successful managers share several key traits. Experience is the most important. Deep CLO management experience provides a combination of credit expertise, access to new deals, trading acumen, risk management, and understanding of the unique needs of CLO tranche and equity investor needs to generate strong returns. Experience managing CLOs through different market environments iscrucial.

Investing inCLOs

An experienced CLO tranche portfolio manager performs rigorous due diligence on CLO managers to understand their capabilities and style, and then tier them accordingly. Each CLO is unique, even if managed by the same CLO manager, so CLO tranche portfolio managers must understand the loan collateral and structural features that drive returns. This involves cashflow modelling and access to underlying CLO portfolio information, as well as real time pricing information to identify potential value. Perhaps most importantly, the ability to “look through “ the CLO collateral portfolio and perform loan-level analysis iscrucial.

A CLO tranche portfolio manager must also take into account overall portfolio exposures in terms of vintage, manager, and underlying sector exposure and conduct ongoing monitoring to identify potential early warning signs in the portfolios. By identifying relative value across the CLO capital stack, CLO tranche portfolio managers can add value by allocating to more attractively valued segments while avoiding overpricedones.

Also important is relative value analysis between primary and secondary market deals, and a CLO tranche portfolio manager must have both access and trading expertise to source attractive deals. From a risk management perspective, the CLO tranche portfolio manager must manage downgrade risk as well as liquidity, and have the ability to “de-risk” the portfolio in times of market stress. There is significant room to add value through an active approach that has flexibility to identify attractivevalue.

An overview of how Pinebridge Investments, sub-advisor for theVanEck CLO ETF (CLOI), selects and constructs a portfolio is outline below:

Benefits of Collateralized Loan Obligations (CLOs)

Built-in Risk Protection: The CLO Structure Is Built toLast

The strong historical performance of the asset class is a testament to the built-in risk protections of CLOs, which starts with the strength of its underlying collateral, i.e. the likelihood the collateral pool will continue to generate sufficient cash flow over the life of a CLO. Leveraged loans (the underlying collateral of CLOs) are senior and secured, meaning they have the senior-most claim on all the issuer’s assets in the event of a bankruptcy. Historically, leveraged loans’ senior secured status has consistently led to lower default rates and higher recoveries compared to unsecured high-yield bonds. CLOs further reduce risk by creating diverse portfolios of leveraged loans—typically 150–250 borrowers—and actively managing thatportfolio.

In addition to the attractive risk profile and active management of its underlying collateral, the structure of CLOs helps mitigate risk. For example, coverage tests are a vital mechanism to detect and correct collateral deterioration, which directly affects the allocation of cash flows. All CLOs have covenants that require the manager to test the portfolio’s ability to cover its interest payments monthly. Among the many such tests, the most common are the interest coverage and overcollateralization tests. Interest coverage dictates that the income generated by the underlying pool of loans must be greater than the interest due on the outstanding debt in the CLO, while overcollateralization requires the principal amount of the underlying pool of loans to be greater than the principal amount of outstanding CLO tranches. As shown below, if the tests come up short, cash flows are diverted from more junior tranches to pay off the most senior tranches first, until these failures arecured.

CLOs Are Structured to MinimizeDefaults

A Guide to Collateralized Loan Obligations (CLOs) (2)

Source: VanEck.This is not an offer to buy or sell, or recommendation to buy or sell any of the securities mentionedherein.

CLOs Are Less Sensitive to Changes in InterestRates

In addition to their strong risk profiles, CLOs are floating rate instruments, reflective of the underlying floating-rate senior loans they hold. This means they have virtually no price sensitivity to changes in interest rates, and coupon payments increase as rates go up. As a result, CLOs have historically outperformed in periods of rising rates. In fact, investment-grade (IG) CLOs have historically provided a more attractive risk/return profile relative to other similarly rated areas of fixed income, such as IG corporate bonds and IG floating ratenotes.

Common Misperceptions aboutCLOs

CLOs fall into the structured credit category, an asset class that includes collateralized debt obligations that held subprime mortgages, a market segment at the epicenter of the 2008 Global Financial Crisis. As a result, the perception exists among some investors that all structured credit is inherently riskier than more traditional fixed income. Historical evidence, however, tells a much different story, especially forCLOs.

CLOs have been tested through two major market crises. Through both the Global Financial Crisis and COVID-19 drawdown, the asset class ultimately experienced fewer defaults than corporate bonds of the same rating. For example, of the approximately $500B of U.S. CLOs issued from 1994-2009 and rated by S&P, only 0.88% experienced defaults. In the higher rated AAA and AA CLO tranches, there have been zero defaults.¹

CLOs Compared to OtherInvestments

Historically, CLOs have offered attractive yields relative to other corporate debt categories, including bank loans, high yield bonds, and investment grade bonds within the same rating category. CLOs have been tested through two major market crises. Through both the Global Financial Crisis and COVID-19 drawdown, the asset class ultimately experienced fewer defaults than corporate bonds of the same rating. We believe this resilience combined with the potential for higher yields and spreads makes the asset class compelling for long-terminvestors.

CLOs have low sensitivity to changes in interest rates due to their floating rate coupons, a characteristic that is similar to leveraged loans but with additional risk protections due to the CLO structure. Further, CLOs trade similarly to bonds and are generally not subject to the extended settlement times associated with loan settlement. These characteristics can be advantageous to investors in diversified fixed incomeportfolios.

Key Takeaways andConclusion

CLOs are securitized, actively managed portfolios of leveraged loans. They have historically offered a compelling combination of both an attractive yield and strong risk profiles. The strong historical performance of the asset class is a testament to the built-in risk protections resulting from how CLOs are structured. In addition, CLOs are floating rate instruments, which means their coupons reset each quarter along with prevailing interest rates, resulting in low price sensitivity to changes in interest rates. This has led to CLOs historically outperforming in periods of rising rates, like the environment we are intoday.

Learn more about theVanEck CLO ETF (CLOI).

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Originally published 7 June, 2023.

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IMPORTANTDISCLOSURES

¹Source: S&P GlobalRatings.

This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities, financial instruments or digital assets mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, tax advice, or any call to action. Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results, are for illustrative purposes only, are valid as of the date of this communication, and are subject to change without notice. Actual future performance of any assets mentioned is unknown. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. VanEck does not guarantee the accuracy of third party data. The information herein represents the opinion of the author(s), but not necessarily those of VanEck or its otheremployees.

An investment in the VanEck CLO ETF (CLOI) may be subject to risks which include, among others, Collateralized Loan Obligations (CLO), debt securities, LIBOR Replacement, foreign currency, foreign securities, investment focus, newly-issued securities, extended settlement, affiliated fund, management, derivatives, cash transactions, market, Sub-Adviser, operational, authorized participant concentration, new fund, absence of prior active market, trading issues, fund shares trading, premium/discount, liquidity of fund shares, non-diversified, and seed investor risks. The Fund may also be subject to liquidity, interest rate, floating rate obligations, credit, call, extension, high yield securities, income, valuation, privately-issued securities, covenant lite loans, default of the underlying asset and CLO manager risks, all of which may adversely affect theFund.

Investing involves substantial risk and high volatility, including possible loss of principal. An investor should consider the investment objective, risks, charges and expenses of the Funds carefully before investing. To obtain a prospectus and summary prospectus, which contain this and other information, call 800.826.2333 or visit vaneck.com. Please read the prospectus and summary prospectus carefully beforeinvesting.

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