A collateralised loan obligation is a single security backed by a pool of corporate debt. With a CLO, the investor receives scheduled debt payments from the underlying loans, assuming most of the risk if borrowers default. In exchange for taking on this risk, investors have greater diversity and the potential for higher-than-average returns.

One of the three-letter acronyms of modern finance is the collateralised loan obligation (CLO), and this tongue-twister relates to entities which use low-cost finance proceeds to buy corporate loans that pay higher rates of interest. They have – unlike some other instruments - been relatively robust since the 2008 financial crisis. 

The author of this article explores what the opportunities in the space are. He is Shawn Cooper, CLO strategy portfolio manager, Orchard Global Asset Management. The editors of this news service are pleased to share these views and invite responses. The usual editorial disclaimers apply. Email tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com

The attraction of owning a business that borrows cheaply from institutional lenders, and then redeploys the capital by lending to European and U.S. businesses at higher rates, is apparent.

Less apparent is that this is what owning CLO (collateralised loan obligation) equity essentially represents. Often confused with other TLAs (three letter acronyms) from the 2008 global financial crisis era, CLOs have generally proven to be resilient and have generated strong returns. Their performance has been driven by this high differential between lending and funding rates, strong cash distributions, and structural improvements to enable them to better weather storms (such as financial crises). Risk management is of course key to successful investing, particularly with regard to managing credit risk of underlying borrowers and mitigating the consequences of any defaults.

Historically, CLO equity has stayed in the background but recent changes in regulation and the dynamics of the contemporary investment landscape have encouraged market participants to offer this tranche of the CLO structure to investors. As an asset manager who manages structured credit, it is our belief at Orchard that risk adjusted returns from the CLO business are currently particularly attractive.

Core economics
The key characteristic of CLOs is that each one is a separate securitized structure that can finance itself cheaply due to healthy demand from institutional investors. CLO equity can be owned outright or through shared ownership with other investors.   

Essentially, a CLO uses low-cost finance proceeds to acquire corporate loans, principally in the US and Western Europe, that pay higher rates of interest. Currently, a CLO can finance itself at around LIBOR + 2 per cent per year and make loans at LIBOR + 4 per cent, providing an equity investor in the CLO company geared exposure to the spread difference. Additionally, the business is well insulated from a rising interest rate environment since the floating rate component of income vs expenditure largely cancels out.

Exhibit 1 – CLO Economics*

Given the current institutional appetite for yield generating assets amid a low interest rate environment, there is ready capacity to finance CLOs. Suppose a typical CLO raises $500 million to engage in lending activity (typically financed with $450 million debt and $50 million equity). Assuming zero defaults in the underlying loans, the business model provides the CLO equity holder, who accepts the asset risk profile, to capture the 2 per cent spread on the entire portfolio, or $10 million of interest, minus typical annual operating costs of $2 million. This creates an 18 per cent cash on cash return for the equity, absent defaults in the portfolio (Exhibit 1). Naturally, defaults will erode the rates of return.
 

Investment considerations
Properly executed, investing in a CLO provides substantial diversification. Loans can be spread across different companies, industries, and geographies.  Furthermore, additional diversification can be obtained through a portfolio of investments across different CLO vehicles and vintages which meet an investor’s risk appetite. Due to this diversification, we believe at Orchard that the optimal approach is to invest across a variety of CLOs.

For an investor looking to build up exposure to CLOs over time, it can be advantageous to work with an experienced specialist who can help to identify viable CLOs and construct a risk weighted portfolio drawing on the best ones.

The value add of a shrewd CLO manager comes from actively buying and selling loans in addition to creating them. Further alpha can be generated from restructuring loans and having strong links to the underlying corporate borrowers to do this effectively. 

Indeed, a manager’s knowledge of the sector and ability to risk manage changes in credits or markets can significantly impact the returns of a CLO portfolio. At Orchard we have managed investments in CLOs through multiple credit cycles (including the 2008 global financial crisis) and have considerable experience in CLO manager selection and due diligence - the vital qualities needed to unlock the full potential risk-adjusted benefits of the asset class.

Additional CLO characteristics
A key benefit available to CLO equity owners is the ability to restructure the CLO borrowings.  After a non-call period (typically 2 years), equity owners have the right to restrike the vehicle’s interest rates to current market levels. In a tightening market environment, restructuring allows CLO equity owners to cut their borrowing costs while maintaining profit margins.  Alternatively, in a widening credit environment, CLOs can keep their long-term borrowing costs fixed while lending at higher rates and leading to improving profitability, subject always to default rates.

The risk-adjusted opportunity set in the CLO sector is thus attractively positioned. Whether from the perspective of absolute return or risk profile, investors are coming to market to finance CLO creation.

Furthermore, the current data shows that institutional investors are putting more money to work in the sector to tap into the elevated returns (Exhibit 2). For equivalent ratings, our research indicates that currently CLO debt can return up to several hundred basis points more than equivalently rated  corporate bonds. This can be attractive in the current low interest rate environment particularly for investors such as heavily regulated life insurance companies who can struggle to satisfy both return objectives and regulatory driven ratings requirements.

Exhibit 2 – Annual flows into CLOs for past 10 years**

Mitigating CLO risk 
Given that CLOs can perform well in widening/tightening credit and rising/falling interest rate environments, the main source of risk is from defaulting companies that have been lent money. However, there are several ways to aim to ensure that losses are minimised. Aside from manager and credit selection, CLO equity owners typically receive annual 15-20% cash distributions from the CLO company which helps to cushion the impact of defaults. 

Moreover, CLOs are designed with a self-protection mechanism. When a specified level of defaults/downgrades is reached, a switch is activated. This temporarily switches off cash distributions, instead using it to reduce borrowing and to buy more assets (typically at wider spreads). These actions help the CLO recover so when cashflows are switched back on, the CLO can be in better financial shape than it was previously.

During the 2008 global financial crisis, for example, CLO cash distributions were paused on average for 1-3 quarters before payments resumed (and when they did resume, they were higher than before). After the 2008 crisis, CLO structures have been strengthened with more stringent lending requirements and greater subordination levels.

Conclusion 
In our opinion CLOs currently offer investors strong risk-adjusted returns with attractive cash distributions, with CLO equity giving investors access to the spread between cheap borrowing and the CLO’s more expensive lending to corporations. A properly diversified, and actively managed, CLO portfolio can help to reduce the effect of defaults even further – while fundamentally CLOs have strong mechanisms in place to protect themselves (and their investors) from the long-term effects of underlying credit events.

Experienced managers have the infrastructure and operational expertise to identify strong CLO businesses, and select and monitor underlying loans. They also have the broad market knowledge and the relationships to identify both value opportunities and partners who are prepared to share the sector’s attractive commercial economics.

Footnotes:

* This is a hypothetical structure provided for the purpose of mathematical illustration only. Returns will vary based on market conditions, and the return on equity will be adversely affected by defaults, and this affect may be material. Your capital is at risk.  Past performance is not guaranteed and is no guide to performance in the future.

** Source: OGAM