Collateralised Loan Obligation (CLO)

A collateralised loan obligation (CLO) is a securitisation vehicle that buys a diversified portfolio of corporate loans and pays for them by issuing notes of different seniority to investors. The loans are mostly senior secured, floating-rate loans to companies rated below investment grade, often arranged to finance buyouts. Interest and principal from the loans are used to pay the noteholders in order of rank.

CLOs are the largest buyers of such loans and a major channel of credit to indebted companies. They belong to the same family as the asset-backed security (ABS) but differ in one important respect: the pool is not fixed. A collateral manager selects the loans and trades them over time within set rules. CLOs are sometimes grouped with collateralised debt obligations (CDOs), of which they are technically a type, though their record has been very different from that of CDOs backed by mortgage securities.

The issuer is a special purpose vehicle with no business other than the transaction. A typical CLO holds between 150 and 300 loans, obtained through loan syndication and the secondary loan market. Its liabilities are divided by tranching:

• Senior notes. The senior tranche, usually rated AAA, makes up around 60% or more of the capital structure and pays the lowest spread.
• Mezzanine notes. Several classes of mezzanine tranche, rated from AA down to BB or B, absorb losses before the senior notes.
• Equity. The equity tranche, roughly a tenth of the structure, is unrated, takes the first losses and receives whatever cash remains after the notes have been paid.

Because both the loans and the notes pay floating rates, a CLO carries little interest rate mismatch. Its earnings come from the gap between the interest on the loans and the cost of the notes, the excess spread, which flows to the equity holders if the structure is performing.

A CLO passes through defined stages. Before closing, the manager accumulates loans using a bank-provided warehouse facility. At closing, the notes are issued and the warehouse is repaid. A ramp-up period follows in which the remaining loans are bought.

During the reinvestment period, usually four or five years, the manager uses principal repayments to buy new loans, so the notes are not repaid. After it ends, principal receipts are used to repay the notes in order of seniority, and the structure gradually shrinks. A non-call period, commonly two years, prevents early redemption; after that, the equity holders can direct the manager to refinance individual classes at lower spreads, to reset the whole transaction with a new reinvestment period, or to liquidate the portfolio and redeem the notes.

Cash is distributed quarterly according to a priority of payments, the securitisation waterfall. Two families of tests protect the senior notes. Overcollateralisation tests compare the par value of the loans, with reductions for defaulted and excess low-rated assets, to the amount of notes outstanding at each level. Interest coverage tests compare interest income with interest due. If a test fails, cash that would have gone to junior notes and equity is redirected to repay senior notes until the test is passed again.

Portfolio quality tests govern the manager's trading. They limit exposure to any single borrower and industry, to the lowest-rated loans and to loans other than senior secured ones, and set targets for average rating, spread and maturity. These features, together with subordination, form the credit enhancement that supports each credit rating.

Banks, insurers and money managers buy the senior notes, insurers and credit funds hold mezzanine notes, and specialist funds and the managers themselves buy the equity. Managers are asset management firms, many affiliated with private equity groups, and are paid a senior fee, a subordinated fee and an incentive fee once equity returns pass a threshold.

Senior CLO notes came through the financial crisis of 2007 to 2009 with very few losses, in contrast to mortgage-related CDOs, and structures issued since then have higher subordination and tighter terms. The risks nonetheless are real. Defaults and low recoveries on the loans erode the junior tranches first. A wave of rating downgrades can breach the limits on the lowest-rated assets and trigger the diversion of cash.

Underwriting standards in the loan market affect all CLOs. Most leveraged loans are now of the covenant-lite type, without the financial maintenance tests that once gave lenders early warning, and recoveries after default may be lower as a result. Regulators and international bodies have drawn attention to the size of the market, to the overlap of holdings between vehicles and to the exposure of banks and insurers through senior tranches.

In the European Union and the United Kingdom, CLOs fall under securitisation rules that require a party with a real economic interest to retain 5% of the transaction, along with disclosure and investor due diligence obligations. In the United States, risk retention rules made under the Dodd-Frank Act initially applied, but in 2018 a federal appeals court held that managers of open-market CLOs were not subject to them, since they do not originate or hold the loans before the vehicle buys them.