1. What is a CLO?

CLO stands for collateralised loan obligation. But this does little to help us understand what a CLO is. A better starting point would be to ask: what is a loan?

Often, high yield companies are those that have gone through a leveraged buyout or LBO (sometimes called a management buyout). This is where a private equity firm buys a company – sometimes a publicly traded company, sometimes a private company and sometimes a division of a bigger company – and increases its level of debt. The private equity firm believes it can do a better job of running the firm than the existing owners. Taking on debt helps the private equity firm pay for the company. If things work out as intended, the return on the private equity investors’ stake will be higher than if the company had a lower level of debt.

The original owners of the company can also make the same bet, that by increasing their level of debt, or leverage, they can improve their returns. So, some high yield borrowers are companies that have not experienced an LBO. They have simply increased their debt, perhaps to fund acquisitions or capital expenditure, or they have borrowed to buy back shares. Others are once highly creditworthy companies that have gone through a downturn in their business. These companies are known as fallen angels.

In 2020, the biggest high yield borrowers included the Pacific Gas & Electric Company which declared bankruptcy in 2019; telecommunications company Lumen Technologies and Ford Motor Company, the American multinational automaker which the US government bailed out in 2009. In 2020, there was $865 billion of US leveraged loan issuance, and $428 billion of high-yield bond issuance according to data from Debtwire. In Europe in 2020 institutional loan issuance was €90.9 billion and high yield bond issuance reached €100.5 billion

In the leveraged finance market it is common to talk about turns of leverage on earnings before interest, tax and debt amortisation (ebitda). One turn of debt is an amount equal to ebitda for one year. So, if a company makes $100 million in profits (before paying its tax or the interest and principal on its debt) and it has $400 million in debt, it is said to have four turns of leverage.

Loans are different from bonds in several ways (see box, previous page), but they serve the same purpose. Before around 1990, a typical loan was owned by a much smaller number of investors than a typical bond. All of these loan investors would have been banks and they would usually hold the loan until it matured (in other words, there was little secondary trading of loans). In the past two decades, the investor base for loans has become much broader (although they are still sometimes referred to as “bank loans”, perhaps because a bank originally makes the loans before distributing them to other investors). A leveraged loan may have dozens or even hundreds of investors and loans are frequently traded as often as bonds.

This is where CLOs come in. A CLO is a kind of fund that specialises in owning leveraged loans. CLOs are now – collectively – the biggest investor in leveraged loans. CLOs are generally between $300 million and $1 billion in size and own loans issued by anywhere between 80 and 300 borrowers.

CLOs that own US loans are the biggest part of the market. There is a smaller set of CLOs that invest in European loans. Historically, there have been a handful of examples of CLOs that own a mix of loans to both US and European borrowers.

The revolver and short dated term loan As are mainly bought by banks and they make up only a small portion of most CLO portfolios. These two types of loans are together referred to as pro-rata loans. The other term loans (B,C and so on) are mainly sold to institutional investors including CLOs, and they make up majority of most CLO portfolios.

There are at least two other pieces of loan market terminology that are also useful to know. Covenant-lite loans (or cov-lite loans) are those that lack certain covenants (see page 7) and they have, at various times, been popular investments for CLOs. Usually a cov-lite loan includes incurrence covenants but not the more stringent maintenance covenants. Both types of covenant impose constraints on the borrower, saying, for example, that debt must not rise above a certain level. The difference between the two is that incurrence covenants are only tested when the borrower takes certain actions, such as selling an asset or issuing new debt. By contrast, borrowers must show they are complying with maintenance covenants on a regular basis, such as once every six months.

The other loan market feature that has become very important for CLOs is known as a Libor floor. This feature affects the interest rate that the loan pays and is described in more detail in chapter 9: How are CLOs priced?

In theory, the manager of a fund is an outside advisor to the company. In practice, the manager of a fund or a CLO is often its driving force (although less so when its capital comes from a single or dominant investor). Of all the service providers to a fund, the manager usually receives the lion’s share of fees. Within certain limits, the manager decides which investments the fund or CLO will buy.

Vehicles that issue debt in tightly controlled tranches are generally referred to as securitisations. Securitisation is the process of putting bundles of similar debt into a vehicle which then issues notes that are secured on those loans. Other kinds of debt that are commonly securitised include car loans, residential mortgages and credit card balances.

Most securitisations are backed by a pool of loans that are either static or are replaced only when they are repaid. The bank that made the original loans is the creator or originator of the securitisation and it replenishes the portfolio when assets repay.

CLOs are different. They have a manager who makes decisions about which loans to buy and sell. The loans do not usually come from the balance sheet of a particular bank. Rather, the manager goes into the market to buy the loans from a variety of sources.

A useful way to think of a CLO is as a hybrid between a fund and a conventional securitisation.

Ratings are opinions about the creditworthiness of a borrower or debt instrument, which are given by companies that specialise in analysing this risk. The leading rating agencies are Fitch Ratings, Moody’s Investors Service and Standard & Poor’s. The symbols used differ from one rating agency to another but generally follow the pattern triple A, double A, single A, triple B, double B, single B, triple C, double C in descending order of creditworthiness.

Ratings are conventionally divided into investment grade (also known as high grade) and high yield (also known as non-investment grade or “junk”). The ratings from triple A down to triple B minus are regarded as investment grade. Double B plus and below are considered high yield.

The double B rating of the most junior debt in a typical CLO indicates that it is a relatively high risk investment, but still somewhat safer than the mid to high single B rating of most loans in the CLO portfolio. A few CLOs also have single B rated notes.

A rule of thumb is that if CLOs perform broadly as they are expected to, there may be a handful of future defaults on double B rated CLO notes, but all tranches rated triple B and above should be safe from defaults. It would take an unprecedented rate of losses in the loan market for the double A and triple A notes to suffer any kind of loss. Indeed, it would require a default rate many times greater than any historically recorded.

Of course, the past is not necessarily a guide to the future. It should be noted that similar claims were made about the safety of collateralised debt obligations (CDOs) backed by sub-prime mortgage securities – which used a similar structure to CLOs. Ratings of mortgage-backed CDOs turned out to be a poor guide to the riskiness of these investments following the subprime mortgage crash of 2007.

However, proponents of CLOs point out that loans have proven themselves to be a much more suitable underlying asset for securitisation than subprime mortgages. For one thing, there is much better data on historical default rates for loans, with statistics going back to before the 1930s depression.

The most senior notes, which benefit from their topmost position in the interest and principal waterfalls and from the early repayment mechanism, are very safe indeed. This makes them an attractive investment for some risk-averse buyers. It also means they can usually benefit from the highest possible rating of triple A.

The more junior notes are riskier but also higher yielding, making them attractive to different types of investors – see Chapter 2: Who are the participants? for more on which investors buy which tranches. The riskiest tranche of all is usually referred to in conversation as equity.

Investors in the equity tranche – just like the owners of a company – have most risk of seeing their investment wiped out. Conversely, they earn the highest return if things go well. Returns on CLO equity can be as high as 30% on an annualised basis.

The key point about securitisation is that it makes the underlying assets – whether they are car loans, credit card receivables or leveraged loans – available to a wider and different group of investors than could buy the assets directly.

This, it can be argued, is a good thing. CLOs bring greater investment into leveraged loans. This means that more companies can borrow – and they can borrow cheaply, fuelling economic activity.

The flip side of this argument is that securitisation can be too effective at bringing investment into an asset class. It may create price bubbles which then burst, as happened with subprime mortgages.

However, many would argue that this is much less likely to happen with corporate debt than with residential mortgages. Corporate borrowing comes from many different sources, such as banks, mutual funds and hedge funds, making it less likely for securitisation to drive loan prices to unsustainable levels.