Collateralized Loan Obligations (CLOs) represent a complex financial instrument that is gaining increasing attention in the investment landscape. This instrument indeed has specific characteristics that can be advantageous within a well-diversified portfolio.CLOs are financial instruments constructed from many bank loans put together. In practice, companies collect a group of loans made to businesses and transform them into securities that are then sold to investors. The process by which all these loans are bundled together and sold as a single product is called securitization – hence the name of these instruments. The loan portfolio is highly diversified: there are many different loans made to various companies in different sectors, with varying levels of risk.
ADVANTAGES OF CLOs Historical Resilience. One of the main strengths of CLOs, particularly those with higher ratings, is their resilience. CLOs with a AAA rating have never recorded a default, demonstrating a remarkable ability to withstand even severe financial crises like that of 2008-09. This feature makes them appealing to investors with a low-risk appetite but seeking higher returns compared to government bonds.Low Correlation. CLOs generally exhibit a low correlation with other investments, a characteristic that makes them particularly useful in terms of building well-diversified portfolios capable of reducing overall risk, lowering volatility without necessarily sacrificing expected returns.
Vehicle for focusing on private credit. CLOs can represent a way to invest in a segment of the private credit market. This allows investors to expand their investment opportunities, markets to include in their portfolios, and seek interesting yields, increasing diversification.Improvement of yield. CLOs can help to increase overall yield, thanks to the higher rates these instruments offer compared to other bond products with similar ratings .DISADVANTAGES OF CLOsComplexity. The complex nature of CLOs can present a barrier for many investors, making it difficult to fully understand the risks and opportunities associated with these instruments.
Limited liquidity. Compared to other financial instruments, the CLO market may exhibit more limited liquidity, especially during market stress periods. This can lead to difficulties in divesting and potential price penalties if there is a need to liquidate positions quickly. Credit risk. Although diversification and the different types of loans provide good protection against risk, there are also subordinated loans or those from companies with low ratings – to clarify, high yield. Therefore, it is essential to carefully select the products to invest in to avoid exposure to overly risky securities.
AND THEN THERE IS THAT CHARACTERISTIC… One of the most relevant features of CLOs is the floating rate structure. The rates of CLOs automatically adjust to changes in benchmark interest rates, and this peculiarity brings both advantages and disadvantages. Being variable-rate makes them particularly interesting in volatile interest rate environments – like the one we are currently experiencing, or during rising rates, because the prices of securities decline less and the coupons become more generous. Conversely, in cases of market downturns, the coupons become less attractive – and thus the yield to maturity – and prices do not rise like fixed income securities, preventing gains from price increases.
CREATION PROCESS OF CLOsThe issuance of CLOs typically occurs through a well-defined securitization process. This process involves the transfer of a portfolio of bank loans from the originating bank (referred to as the Sponsor) to a specially created company, known as a Special Purpose Vehicle (SPV). This entity, in exchange for the purchase of the portfolio, finances itself by issuing CLO securities that will then be placed on the market. The securitization process allows for the transformation of illiquid assets (bank loans) into tradable instruments, thereby increasing the efficiency of the financial market and providing investors access to asset classes that would otherwise be difficult to reach.
A fundamental characteristic of CLOs is their tranche structure, which involves the issuance of different classes of securities with varying degrees of risk and priority in repayments. This stratification allows investors to choose the level of risk exposure that best suits their needs: 1. Senior Tranche: represents the safest class, typically rated AAA, which is repaid first in terms of both principal and interest. Historically, these tranches have demonstrated remarkable resilience, having never defaulted even during the financial crisis of 2008-09. 2. Junior Tranche: a class with secondary priority in repayments, characterized by higher risk and higher returns compared to senior tranches. 3. Subordinated Tranche: represents the riskiest class, which is repaid last and therefore absorbs the first losses of the underlying portfolio.
PROTECTION MECHANISMS The structure of CLOs incorporates various coverage tests and evaluations of the quality of guarantees to identify and mitigate the erosion of the quality of the underlying assets. If these tests yield negative results, cash flows are redirected to provide greater protection to senior security holders, while simultaneously limiting the reinvestment flexibility of CLO managers. This mechanism can make CLO securities with high ratings particularly attractive during periods of market turmoil, as it reduces the financial leverage of the structure and decreases the weighted average life of the safest securities.