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Collateralized Loan Obligation, CLO in recent years, has become popular in markets as many investors have recognized its potential.
A CLO gives investors the chance to buy an interest known as “Tranche” in a heterogenous portfolio of company loans.
It should however be noted that each tranche comes with its own risks.
What is a CLO?
A collateralized loan obligation (CLO) is a securitization backed by corporate loans taken out by private equity firms to carry out leveraged buyouts. Each CLO is structured as an array of tranches that are interest-paying bonds plus a small portion of equity.
How it works is that the company selling the CLO will buy a huge number of corporate loans from private companies and private equity firms, package them, and then sell them to investors in what is known as “tranches”.
CLOs are usually overseen by a CLO manager. It is wise to invest where there is a competent CLO manager who will do his job excellently.
The inception of CLOs can be traced back to the late 1980s. It was designed as a way for banks to put together leveraged loans to give investors an investment vehicle with wide-ranging degrees of risk and return to best suit their investment purpose.
The CLO Process
There are certain steps involved in the creation of a CLO.
1. The first step is to set up a capital structure, i.e. different levels of debt and equity forming the base of the security.
2. The next step is to gather capital from investors.
3. Investors then choose a tranche their best suits their investment purpose.
4.The CLO manager will then use the capital that was gathered from investors to buy loans.
5. A special purpose vehicle (SPV) is then made to share the CLO securities.
6. The next step is to pay investors, starting with the most senior tranche.
7. Once all the securities have been repaid, the CLO transaction may end.
Perks of a CLO
There is a lot of perks that comes with investing in a CLO and here are some of them:
1. CLOs expose investors to a heterogenous pool of loans granted to non-investment grade borrowers.
2. Since there are different levels of credit risk, investors in the senior tranches are provided with additional protection against losses.
3. Investors have access to professional management and expertise in the credit markets.
4. CLOs give higher yields compared to other fixed-income investments.
5. Another benefit of a CLO is that investors can manage their portfolios and easily quit their positions whenever they have to.
Risks to Consider
1. CLOs are subjected to liquidity risk.
2. Sometimes, they are are incredibly complex.
3. If the borrower of a particular loan pays earlier than expected, it will harm the returns of an investor.
4. There is usually a higher interest rate risk involved.
A CLO is divided into debt tranches and then ranked according to the creditworthiness of the underlying loans.
It is ranked like this:
- AAA Tranche
- AA Tranche
- A Tranche
- BBB Tranche
- BB Tranche
- Equity Tranche
Role of the CLO Manager
1. They pool the securities products.
2. They help to manage the output of the portfolio of loans within the CLO.
3. They help to palliate any risk to the overall structure.
4. They identify and rectify any impairment to the collateral.
How to Choose the Right CLO Manager
As a CLO investor, you want to choose the right CLO manager and here are some traits that we think you should look for in a competent CLO manager.
1. Go for a CLO manager with extensive management experience.
2. Choose a manager with great trading skills.
3. Pick a manager who is an expert at risk management.
4. Pick a manger who has your best interests at heart, not one who is just looking to make money for himself.
As an investor, it is wise to carry out as much research as you can before purchasing an interest in a Collateralize Loan Obligation (CLO), so you can get your money’s worth instead of throwing money away.