Guide to CLOs

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?
What is a loan?
When we talk about loans in the context of CLOs we don’t mean just any loans, we mean loans made to companies that have high levels of debt. These are usually called leveraged loans or high yield loans. The companies that borrow these loans are often the same companies that borrow using high yield bonds, also called junk bonds.
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

Risk and return

High yield companies are statistically more likely to default than companies with lower levels of debt, (known as investment grade borrowers).
So the people who lend money to high yield companies (that is, lenders, or investors in their debt) expect to receive a higher return (for example, more interest) than they would on an investment grade company’s debt.
Historically, the average annual default rate for US high yield companies is somewhere around 4-5%. The default rate for investment grade companies is lower, usually estimated at much less than 1%.
The probability of default of any given company is unknowable. But the yield that investors are prepared to receive for holding each borrower’s debt gives us an indication of how likely investors think that company is to default (and how much money they will lose if there is a default). In other words, there is a market-implied view of default.
Broadly, a high yield company’s debt has a yield that is (in 2021) around 2.3 percentage points higher than that of an investment grade company. In other words, the high yield company pays 2.3 percentage points more each year to borrow than the investment grade company.
High yield companies leverage
Indebtedness is usually expressed in terms of turns of leverage. Leverage can be defined in different ways. One way is to compare the amount of debt the company owes to the size of its equity (mainly paid up shares and retained earnings). Alternatively, leverage can be a comparison between the size of the company’s debt and the amount of profit it makes each year (see table, previous page).

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.
Where do these loans come from?
When a company wants to issue a bond or loan it typically engages an investment bank to help it raise funds from a large number of investors. In the case of a bond, the investment bank (or arranger) may sell the bond to hundreds of different investors. They all become lenders to the company. They own a security that pays regular interest and repays the original investment amount (the principal) when it matures. Investors can wait until the bond matures to get their principal back. If they want their money back before maturity, they can usually sell a bond to other investors.

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.

Bonds and loans: what’s the difference?

A corporate bond and a corporate loan are very similar in concept. Both are relevant to the CLO market but, as we will see in later chapters, loans are much more important.
Bonds and loans are both debts made when an investor (or, more likely, a group of investors) lends money to a company. Both carry a rate of interest and an obligation to pay back the original amount, or principal, within a certain time frame. In both cases, the debt can be sold (traded) by the original investor to another investor.
It is useful to think of bonds and loans as competing market places for the same essential product. But each market has different conventions and terminology. This gives rise to some important differences.
Loans typically have security whereas bonds are usually unsecured. Being secured means that loan holders have the right to seize the assets of the company, such as machines or property, in a liquidation. Unsecured creditors need to be paid back from any other assets the company may have. This means that when defaults occur, even if the company is not liquidated, secured credits typically lose less money than bond holders. In other words, they have, on average, a higher recovery rate.
Historically, leveraged loan recovery rates have been around 70% to 80% in the US, whereas those on high yield bonds have been between 40% and 50%*. In recent years recovery rates have diverged from those historical norms, with many US high yield bonds recovering in the singles digits in 2019 and 2020.
Loan investors usually have more control over what a borrower can and cannot do than bond investors. These restrictions are referred to as covenants. They vary greatly from borrower to borrower. Typically, they stop the borrower from taking on more than a certain amount of leverage or limit the amount of capital expenditure the borrower can carry out.
Bonds usually pay interest at a fixed rate. In other words, they carry an interest rate (or coupon) which is fixed at, say, 5% a year for the life of the bond. Loans usually pay what is known as a floating rate of interest. They pay a margin of perhaps 4% on top of a benchmark interest rate (such as Euribor, an interest rate at which banks lend to each other).
Bonds usually repay all their principal at the same time on maturity. This is called a bullet maturity. Loans often amortise, which means that their principal is repaid gradually as the loan nears maturity. However, the type of loans most frequently found in CLOs have either bullet maturities like bonds or repay only a small portion of their principal before maturity.
Borrowers can usually repay (or call) a loan any time they want without penalty, or for only a small extra payment to investors. Bonds, by contrast, can only be called at certain times. In other words, bond holders benefit from call protection whereas loan investors generally do not.
Bonds and loans can both be traded in the secondary market. But the process of trading the two instruments is different in practical and legal terms. One big difference is that loan trades take much longer to settle (become legally complete) than bond trades.
*Between 1989 and 2010 loan recoveries were 80.4% on average according to Moody’s, while those on bonds were 48.4%.
Funds can buy “bank” loans
As well as banks, investment funds such as mutual funds and hedge funds also own loans. Funds provide a way for individual investors to pool their capital to increase their buying power and give them access to investments which might not be available to an individual investor.

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.
A typical balance sheet for a high yield company
Pinch to zoom in
‘One of the most important distinctions is between revolving loans and term loans’

What’s in a name?

CLOs issue debt in the form of bonds or notes.
We will refer to them as notes to avoid confusion with bonds issued by “real” companies.
It is these securities that were originally called “collateralised loan obligations”, borrowing the term from the earlier collateralised bond obligation and the even earlier collateralised mortgage obligation.
Today, the term CLO usually refers to the whole vehicle rather than to the individual notes that it issues.
Easy as ABC
There are many types of loans. One of the most important distinctions in the loan market is between revolving loans (revolvers), which act like a bank overdraft, and term loans, where the borrower receives all the money at the outset. Many leveraged loan borrowers have as their shortest maturity loans a revolver and an accompanying term loan known as the term loan A. Equal in seniority (but longer in maturity) come a term loan B, a term loan C, and sometimes a term loan D and so on.
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?
How are CLOs different from other funds?
Like other funds, CLOs are usually set up as companies (or sometimes partnerships), but they are companies with a very limited purpose and no staff of their own (for this reason they are often called special purpose vehicles). Like hedge funds, these companies are usually based in jurisdictions that pay no corporation tax. And like most funds, CLOs have a manager, a company which makes decisions on behalf of the fund.
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.
CLOs differ from most other funds in four key ways.
  1. Finite life. The CLO has a predetermined life span. There is a final maturity date at which it will be unwound and its investors repaid. In practice, investors will most likely get their money back long before then.
  2. Limited redemption. The original investors’ money is locked away longer and more tightly than in most funds. In a typical fund, individual investors can exit and the fund will carry on without them. A CLO can only be redeemed if its equity investors vote to wind it up, and they can only do so once the CLO has been in existence for several years. If individual investors want to exit, their only choice is usually to sell their position to another investor.
  3. Leverage. Like the companies whose loans they invest in, CLOs borrow money to increase their equity investors’ returns. Unlike with some other funds, this debt is committed for the lifetime of the CLO (so called “term funding”). In other funds, the providers of debt have the right to demand repayment if the value of the fund’s investments falls below a certain level. This is called market value-based funding and it is similar to an investor buying investments on margin from a broker. This does not happen in a conventional CLO.
  4. Protection for debt investors. The CLO’s note holders commit their money for the life of the CLO. In return they benefit from a feature that protects them if the CLO’s investments perform poorly. If defaults or trading losses reach a certain level, cash that would otherwise go to equity and more junior debt investors is diverted to pay down their debt. But here is an important point: this repayment or deleveraging does not happen just because the market value of the CLO’s investments falls. We will explain how this feature, usually known as the overcollateralisation test, works in chapter six: Understanding the tests
Where does the cash go?
The overcollateralisation test is one feature that protects CLO noteholders. Another is that the CLO follows strict rules about what it does with cash it receives from its investments. In a CLO, all the interest payments coming into the vehicle are allocated to investors in a defined order. This is called the interest waterfall. There is a similar but separate cashflow waterfall for all principal payments, the principal waterfall. (See chapter 5: Understanding the cashflows for an explanation of how the waterfalls work).
Talking about tranches
The purpose of the interest waterfall and the principal waterfall is to make some notes more senior (and therefore less risky) than others. If the amount of cash coming into the CLO falls, junior note investors will lose out before senior note holders. Similarly, the overcollateralisation mechanism is set up so that senior investors get repaid first if there are a lot of defaults in the CLO’s investment portfolio. The different layers or classes of debt issued by a CLO are referred to as “tranches”.

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 and risk
How risky is risky? The most senior tranches of a CLO should be very low risk indeed. Historically, there have never been any losses on these notes in the history of the CLO market. These notes are typically rated triple A. This is the highest possible credit rating and means that triple A CLOs have a higher rating than many large developed countries.

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.
What’s the point of tranches?
Whether in a mortgage-backed security or a CLO, securitisation is a mechanism to turn the relatively homogeneous credit risk of a large portfolio of loans into notes with very different risk characteristics.
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.