11. VARIETIES OF CLO
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11. Varieties of CLO
CLOs have never been a simple product. They evolved from earlier collateralised bond obligations, which in turn inherited the structure of earlier forms of securitisation.
Added extras
Each new generation of CLOs has bolted extra features onto the structure, such as triple C buckets and discount purchase rules (see chapter 6: understanding the tests). This means that different vintages of CLO have different structural characteristics.
Nor are CLOs in any way standardised, although many of their indentures and other documents will borrow clauses from other CLOs. While there are regular calls for participants to embrace a standard template for CLOs, each arranger, manager and investor tends to have different preferences and requirements for the way deals are created. This leads to a proliferation of different structures, even among deals which appear to be very similar.
CLO 3.0 and beyond
CLO 3.0 and beyond
The term CLO 3.0 was introduced to the market to refer to CLOs structured to comply with the Volcker rule (see chapter 12: CLOs and regulation) by having no bond buckets (in other words, they are allowed to buy only loans and not bonds of any kind).
However, the term 3.0 has not proved as popular as 2.0, and with only a handful of 1.0 CLOs remaining outstanding CLOs have become mostly simply CLOs again.
In reality, while there are real differences between 2.0 and 1.0 CLOs, the distinction is perhaps no greater than that between other vintages. Market participants certainly played up the contrast between new deals and older deals in order to distance the product from the CLO and CDO market of the past.
1.0 versus 2.0
CLOs launched since the financial crisis tend to have several features in common with each other that are not shared by older, pre-crisis deals. As arrangers and managers looked to launch new deals in the wake of the crisis, they started using the term CLO 2.0 to refer to them. They did this in order to emphasise how different the new deals were from existing deals (which then became known as CLO 1.0). This was at a time when most CLOs had suffered sharp falls in value and there were fears that many were heading towards events of default.
The standard template for post-crisis CLOs was a four-year reinvestment period and a non-call period of two years. By contrast, pre-crisis CLOs had much greater variation in the length of their reinvestment and non-call periods, and these were generally much longer than in post-crisis deals. Over the years that contrast has faded. Most deals now price with a five-year reinvestment period, and the shorter dated deals are frequent.
Most of the changes introduced as the US CLO market reopened in 2009 were designed to make the product more appealing to debt investors, who generally favour short reinvestment periods and greater certainty about how long the deal will be outstanding. However, some features, such as the short non-call period and tranche-by-tranche refinancing and repricing, were introduced to allow equity investors to take advantage of future falls in CLO spreads (see chapter 7: Debt tranches and ratings).
Getting flexible
After a long hiatus 2015 saw the return of the CBO. Although CBOs predate the CLO market they fell out of favour before the financial crisis. The new generation included both loan and bonds in their portfolio, and have become known as bond-flex CLOs to differentiate them from the old bond-only approach. As well as large bond buckets these deals are also priced with fixed-rate tranches.
Now that the Volcker restrictions on CLOs have been lifted many market participants are expecting the boundaries to blur further as small bond buckets return to many new deals.
Bonds aren’t the only innovative approach managers have taken to CLO assets. Triple-C flex CLOs are designed to take advantage of any pricing dislocations seen for triple-C loans, which are shunned by most CLO managers due to their impact on par values (see Chapter 6: Understanding the test). The size of the triple C bucket varies, but is generally around 50% of the portfolio.
Both bond-flex and triple-C flex CLOs remain a niche product at the moment.
Borrowers large and small
Another real but somewhat blurred divide in the CLO market is between deals backed by large company loans and those backed by loans to smaller companies. The second type of deal is known as a mid market CLO. These are usually regarded as a breed apart from the majority that buy large cap loans. In reality, there is some overlap between the two products.
Mid market loans are usually defined as those to companies with earnings of $50 million or less, while anything bigger is usually described as a broadly syndicated loan.
The way loans are sold or originated is subtly different in the two sectors. Larger company loans are usually arranged (or “syndicated”) by an investment bank, which markets the debt to a large number of investors through a roadshow. In the mid market, a small club of lenders join forces to make the loan.
Mid market loans are much less frequently traded than broadly syndicated loans. For the most part, the original investor holds the loan for its entire life. So, mid market CLOs tend to have more static portfolios than other CLOs.
Another characteristic of mid market loans is that they tend not to be publicly rated. Instead, they usually carry shadow ratings (see chapter 7: Debt tranches and ratings).
Mid market CLOs have been much less popular with investors since the crisis than CLOs of broadly syndicated loans. At the start of 2021 there were 147 outstanding mid market CLOs, compared to 1397 broadly syndicated US CLOs.
Rather than being two completely separate products, there is a continuum between large cap and mid market CLOs. Many CLOs include a few loans from smaller companies, and many managers are active in both the mid market and broadly syndicated sectors.
When banks issue CLOs
One term that can lead to confusion is balance sheet CLO. A balance sheet CLO is one in which an entity, most commonly a bank, securitises an existing portfolio of corporate loans. In the early days of the CLO market, especially in Europe, it was common for commentators to divide the market into balance sheet deals on the one side and those put together by an asset manager on the other. The second type of deal – which is now by far the most common – was often referred to as an “arbitrage” CLO.
In Europe, bank balance sheet CLOs continue to exist. The bank originator retains the equity tranche and usually acts as the deal’s manager in a limited fashion, substituting new assets when loans are repaid, for example.
But the distinction between balance sheet and arbitrage CLOs is not a robust one. Any CLO exists only if there is an arbitrage in the sense of a difference between the yield on the assets and the cost of issuing liabilities (at least when measured in terms of a bank’s regulatory capital).
Furthermore, there are many examples of CLOs where the manager retains the equity tranche. These can also be considered balance sheet CLOs, since the CLO liabilities are part of the manager’s consolidated balance sheet.
Indeed, this model of CLO origination has become more common in future as a result of regulatory pressure. European CLO risk retention rules (see chapter 12: CLOs and regulation) require the deal’s manager to retain 5% of the CLO liabilities. One way this can take place is if a manager sets up or sets itself up as a vehicle to buy loans and then securitises them.
Standing still
Although the vast majority of CLOs are actively managed, there has been a growing trend in recent years for static CLOs. First pioneered by Palmer Square, a number of other managers have begun to issue static deals alongside regular CLOs.
These static deals have a number of structural differences to arbitrage CLOs. As their name implies, the manager is unable to trade assets in the portfolio except in very limited circumstances. They also have much shorter lifespans, with a one-year non-call period as standard.