What is a secured loan obligation (CLO)?

A secured loan obligation (CLO) is a single security backed by a pool of debt. The process of pooling assets into a marketable security is called securitization. Secured Loan Bonds (CLOs) are often backed by loans to businesses with low credit ratings or loans taken out by private equity firms to carry out projects. leveraged buyouts. A secured loan obligation is similar to a secured mortgage bond (CMO), except that the underlying debt is of a different type and character: a business loan instead of a mortgage.

With a CLO, the investor receives scheduled debt payments from the underlying loans, assuming most of the risk in the event the borrowers default. In return for assuming the risk of default, the investor is offered greater diversity and the potential for above-average returns. A fault This is when a borrower does not make payments on a loan or mortgage for an extended period of time.

How Secured Loan Bonds (CLOs) Work

Loans (typically senior corporate bank loans) that are rated below investment grade are initially sold to a CLO manager who pools multiple loans (typically 100-225) and handles consolidations, actively buying and selling loans. To finance the purchase of new debt, the CLO manager sells stakes in the CLO to outside investors in a structure called slices. Each installment is a part of the CLO, and it dictates who gets paid first when the underlying loan payments are made. It also dictates the risk associated with the investment since investors who are paid last have a higher risk of defaulting on the underlying loans. Investors who get paid first have lower overall risk, but therefore receive lower interest payments. Investors who are in later installments may be paid last, but the interest payments are higher to offset the risk.

There are two types of tranches: debt tranches and equity tranches. Debt tranches are treated like bonds and have credit ratings and coupon payments. These debt tranches are still in the lead in terms of refund, although within the debt tranches, there is also a pecking order. The equity tranches have no credit rating and are paid after all debt tranches. Tranches of shares rarely receive cash flow but offer ownership of the CLO itself in the event of a sale.

A CLO is an actively managed instrument: managers can buy and sell individual bank loans in the underlying collateral pool with the aim of scoring gains and minimizing losses. In addition, most of a CLO’s debt is backed by high quality collateral, making liquidation less likely and making it better equipped to withstand market volatility.

Special considerations for CLOs

Some people claim that a CLO is not that risky. A study by Guggenheim Investments, an asset management company, found that from 1994 to 2013, CLOs experienced significantly lower default rates than corporate bonds. Even so, these are sophisticated investments, and usually only large institutional investors buy tranches in a CLO. In other words, large companies, such as insurance companies, quickly buy senior debt tranches to ensure low risk and stable cash flow. Mutual funds and ETFs buy normally junior debt tranches with higher risk and higher interest payments. If an individual investor invests in a mutual fund with junior debt tranches, that investor assumes the proportional risk of default.

Frequently Asked Questions

What is a secured loan obligation (CLO)?

A secured loan bond (CLO) is a type of security that allows investors to acquire an interest in a diversified portfolio of business loans. The company that sells the CLO will buy a large number of business loans from borrowers such as private companies and private equity firms, and will then consolidate these loans into a single CLO title. The CLO is then sold to investors in a variety of coins, called “tranches”, with each tranche offering its own risk-reward characteristics.

What is the difference between a debt tranche and an equity tranche?

There are two main types of slices used when selling a CLO: debt tranches and equity tranches. Debt tranches are those that provide the investor with a specified stream of interest and principal payments, similar to those offered by other debt instruments such as debentures or corporate bonds. Equity tranches, on the other hand, do not pay a scheduled cash flow to the investor, but instead offer a share of the value of the CLO if the CLO is resold in the future. Within each of these categories, many different tranches may be available, with the riskier tranches offering higher potential returns.

What is the difference between a CLO and a Collateralized Mortgage Obligation (CMO)?

CLOs are similar to Guaranteed mortgage bonds (CMO), in that both securities are backed by a large portfolio of underlying debt securities. The main difference between them, however, is that CLOs are based on debt owed by companies, while CMOs are based on mortgages. CLOs and CMOs are examples of credit derivatives.