May 01, 2019
A CLO is a type of structured credit. Structured credit is a fixed-income sector that also includes asset-backed securities (ABS), residential mortgage-backed securities (RMBS), and commercial mortgage-backed securities (CMBS). CLOs purchase a diverse pool of senior secured bank loans made to businesses that are rated below investment grade. The bulk of CLOs’ underlying collateral pool is comprised of first-lien senior-secured bank loans, which rank first in priority of payment in the borrower’s capital structure in the event of bankruptcy, ahead of unsecured debt. In addition to first lien bank loans, the underlying CLO portfolio may include a small allowance for second lien and unsecured debt.
CLOs use funds received from the issuance of debt and equity to acquire a diverse portfolio of senior secured bank loans. The debt issued by CLOs is divided into separate tranches, each of which has a different risk/return profile based on its priority of claim on the cash flows produced by the underlying loan pool. Senior secured bank loans from a diverse range of borrowers—typically 150–250 companies—are pooled in the CLO and actively managed by the CLO manager. Economically, the CLO equity investor owns the managed pool of bank loans and the CLO debt investors term-finance that same pool of loans.
Portfolios of bank loans, also known as leveraged loans, act as the collateral supporting CLOs. Leveraged loans are senior-secured loans to below investment-grade companies. CLO portfolios are actively managed over a fixed tenure known as the "reinvestment period," during which time the manager of a CLO can buy and sell individual bank loans for the underlying collateral pool in an effort to create trading gains and mitigate losses from deteriorating credits.
As senior secured claims, these loans enjoy the senior-most claim on all the related company’s assets in the event of a bankruptcy and represent the least risky investment in these companies. As you can see in the charts below, leveraged loans’ senior secured status has consistently led to lower default rates and higher recoveries compared to unsecured high-yield bonds. CLOs further mitigate default and recovery risk for individual company credits by creating diverse portfolios of leveraged loans—typically 150–250 borrowers—and actively managing that portfolio.
The long-term average trailing 12-month loan default rate is 2.8 percent, according to Wells Fargo data. However, through careful credit selection and active trading, CLO managers may be able to limit annual portfolio loss rates.
Source: Guggenheim Investments, Wells Fargo. Data as of 2.1.2019.
Source: Guggenheim Investments, Moody's. Data as of 12.31.2018.
To purchase the portfolio of loans, the CLO raises money by selling debt and equity securities. The debt and equity securities are sold in tranches, where each CLO tranche has a different priority of claim on cash-flow distributions and exposure to risk of loss from the underlying collateral pool. Cash-flow distributions begin with the senior-most debt tranches of the CLO capital structure and flow down to the bottom equity tranche, a distribution methodology that is referred to as a waterfall.
Source: Guggenheim Investments. Collateral pools for most CLOs also have a small allowance for second lien and unsecured debt.
The cash-flow waterfall, in connection with performance-based tests, provides varying degrees of protection to the CLO’s debt tranches. The most senior and highest-rated AAA tranche has the lowest yield but enjoys the highest claim on the cash-flow distributions and is the most loss-remote. Mezzanine tranches pay higher coupons but are more exposed to loss and have lower ratings. The most junior tranche, equity, is the riskiest, is not rated, and does not have a set coupon. Instead, the equity tranche represents a claim on all excess cash flows once the obligations for each debt tranche have been met.
CLOs face a series of coverage tests to help ensure the cash flows generated by the underlying bank loan collateral meet the distribution obligations in the various CLO tranches. One such test is an overcollateralization test, which helps to keep the principal value of a CLO’s underlying bank loan pool from exceeding the total principal value of the notes issued by the various CLO debt tranches as long as the CLO debt remains outstanding. If the principal value declines below the overcollateralization test trigger value, cash will be diverted away from equity and junior CLO debt tranches toward senior debt tranche investors.
For example, consider a hypothetical CLO created with $500 million of principal promised to the owners of its various debt tranches. To meet this $500 million obligation, investors and rating agencies may require that the CLO manager use the capital raised from the CLO’s debt and equity issuance to purchase $625 million of bank loans. This would result in an overcollateralization ratio of 1.25.
CLO Lifecycle: CLOs typically last eight to 10 years, during which time the vehicle reaches a series of milestones.
Warehouse Period: A warehouse provider finances the CLO manager's acquisition of leveraged loan assets. The warehouse period typically takes six to 12 months. The warehouse loan is expected to be paid off with the proceeds from the CLO's issuance.
Ramp-Up Period: After closing, the CLO manager uses the proceeds from the CLO issuance to purchase additional assets. The ramp-up period usually lasts three to five months and culminates with the ramp-up end date.
Reinvestment Period: The collateral manager is permitted to actively trade underlying assets within the CLO and uses principal cash flow from underlying assets to purchase new assets. The reinvestment period may last up to five years.
Non-Call Period: During the non-call period the equity may not call or refinance the CLO debt tranches. Non-call periods may last six months to two years, depending on the length of the reinvestment period. The non-call period ends two years after a CLO’s closing date. At that point, investors in the equity tranche of the CLO can refinance their positions.
Amortization Period: After the reinvestment period ends, the CLO enters its amortization period, during which cash flows from the CLO’s underlying assets are used to pay down outstanding notes. The amortization period represents the concluding phase of a CLO’s lifecycle.
Hypothetical example for illustrative purposes only. Please see Disclosures for a more complete discussion of risks of investing in CLOs. *By design, CLO equity tranches receive much of their return from excess spread distributions. Return of stated principal is highly variable.
In practice, each CLO debt tranche has its own targeted overcollateralization ratio. The overcollateralization ratios for each tranche act as covenants and, when tripped, redirect cash flows to purchase additional bank loan collateral or repay the senior-most CLO debt tranche.
CLOs are also subject to a variety of other tests that act in concert in an effort to help protect debt investors from loss. Examples of these tests include a measurement of the industry diversification in the underlying collateral pool of bank loans, and the CLO’s exposure to non-senior secured loans. Other tests consider the diversity of borrowers underlying each CLO and set single obligor limits. There are also limitations on the amount of CCC-rated debt that can be included in the underlying collateral pool, which helps contain negative credit drift.
Finally, CLOs mitigate default and recovery risk for individual company credits by actively managing the leveraged loan portfolio. Once a CLO is created, the manager can actively manage the portfolio for the benefit of the debt and equity holders. Because post-crisis CLOs (so-called CLO 2.0) are not subject to mark-to-market tests, the manager will only buy and sell individual bank loans seeking to create trading gains and minimize losses from deteriorating credits, not to manage market price pressures. Nearly all CLOs are not mark-to-market vehicles and have extremely high hurdles to meet before collateral liquidation is triggered, making them better equipped to potentially withstand market volatility. With strong structural protections and historically low default rates, investment-grade CLOs can present an attractive opportunity without assuming undue credit risk.
Source: Guggenheim Investments.
The structured credit marketplace has evolved significantly since the financial crisis. The CLO market grew from a post-crisis trough of $263 billion to $590 billion as of January 2019, according to Wells Fargo research. The strong historical credit performance and attractive floating-rate coupon attracted many new investors to the space. Prior to the financial crisis, investor sponsorship was largely dominated by hedge funds, structured investment vehicles (SIVs), and Wall Street trading desks. However, post-crisis regulation has all but eliminated these highly leveraged investor types. Today’s investor base is primarily composed of money center banks, large institutional asset managers and insurance companies. These real-money investors do not employ the high leverage strategies of the pre-crisis investor base and, as a result, are less prone to the binge-and-purge trading styles that stem from mark-to-market and margin call pressures.
Source: Guggenheim Investments, SIFMA, Wells Fargo, Credit Suisse. Data as of 3.31.2018.
At $590 billion, CLOs represent half of the total $1.2 trillion U.S. leverage loan loan market. About 65 percent of CLO market debt is AAA-rated and is typically held by banks and money managers. A further 23 percent of the market is made up of AA, A, and BBB-rated debt, tranches that are typically held by banks, money managers, and insurance companies. The riskier tranches—BB and equity—round out the remaining 12 percent and tend to attract hedge funds, business development companies, publicly traded vehicles, or locked-up risk retention funds. Borrowers rated below investment grade typically pay a premium of 200–500 basis points over Libor to service their debt.
Source: Guggenheim Investments, S&P Global Market Intelligence, Wells Fargo. Data as of 3.31.2019.
The chart below shows that secondary trading volumes in both investment-grade and non-investment grade CLOs remained stable post-crisis, including the 2013 “taper tantrum” and the market correction in the first quarter of 2016.
Source: Guggenheim Investments, TRACE. Data as of 4.10.2019.
The combination of conservative collateral and sound securitization structure has resulted in strong credit performance. In fact, AAA and AA-rated CLO tranches have only experienced one default since 1994, even during the financial crisis. CLOs’ historically low default rate holds true across the ratings spectrum (see table below).
While CLOs exhibited strong and resilient credit performance during the financial crisis, post-crisis CLOs feature numerous additional credit improvements compared to their pre-crisis counterparts. First, rating agencies now require that CLOs feature substantially more credit enhancement to each rated debt tranche compared to their pre-crisis counterparts. Second, where pre-crisis CLOs were able to make investments in subordinated bonds and other CLO debt instruments, post-crisis CLOs are collateralized primarily by senior secured bank loans. Lastly, post-crisis CLOs' documentation is much more investor friendly, shortening the trading period during which the manager is able to actively manage the loan portfolio, and limiting extension risk for CLO securities. Thus far among CLO 2.0, 43 post-crisis tranches have been downgraded by S&P or Moody's since 2012, and more than 70 percent of those downgraded tranches are 2014 vintages with most of the balance from 2013. Over half of the tranches were originally rated single B with no downgrades of CLO 2.0 AAA or AA tranches.
Source: Guggenheim Investments, S&P Global Ratings. Data as of 4.10.2019.
Core fixed-income investors continually evaluate current and prospective market conditions and assess relative value across a range of asset classes when making portfolio allocation decisions. A portfolio manager’s job is to construct a portfolio that is designed to deliver compelling returns in a wide range of outcomes. As these outcomes materialize, managers look to different sectors to perform in different ways to contribute to overall performance. The task of assessing relative value—pricing the risk and reward of possible investments—occurs within the context of a portfolio’s overall asset allocation structure.
CLOs have several features that make them an integral component of Guggenheim’s fixed-income mutual funds, and institutional portfolios. In addition to their investor-friendly structural protections and credit performance, one of the most important characteristics of CLOs is their floating-rate coupon. CLOs’ floating-rate coupons help defend investors against loss in a rising interest rate environment. Fixed-rate securities, as with most government and corporate debt, decline in value as interest rates rise, and investors discount the value of fixed-rate bonds' relatively less attractive coupons. However, the coupons on floating-rate securities such as CLOs adjust based on the current short-term interest-rate environment. As a result, floating-rate securities’ prices tend to be more stable in rising interest rate environments than those of their fixed-rate counterparts.
Investing in CLOs is not without risk. As with other securities, CLOs are subject to credit, liquidity, and interest-rate risk, and the specific structure of CLOs means that investors must also understand the waterfall mechanisms and protections as well as the terms, conditions, and credit profile of the underlying loan collateral. Thus, the relative value determination for a CLO is not only its potential return relative to other fixed-income sectors, but also its pricing relative to other short-duration options, and relative to the amount of risk in the security.
At Guggenheim, we have found that CLOs generally pay a spread over their benchmark—typically three-month Libor—that is attractive relative to other securities with similar ratings.
To capture opportunities in the CLO market, investment managers require the expertise to perform rigorous bottom-up research on individual bank loans in the underlying collateral pool. Since some CLOs have as many as 250 borrowers in their collateral pools, investment managers must have significant corporate credit research capabilities to fully evaluate the underlying credit risk in each CLO.
At the same time, the importance of understanding a CLO’s structural characteristics cannot be underestimated. Two CLOs with identical collateral assets may produce varied performance due to structural differences. Additionally, the legal documentation that governs a typical CLO can be in excess of 300 pages. While CLOs can offer compelling relative value, investors require the appropriate mix of credit research, structuring, and legal expertise to effectively capitalize on this market opportunity.
Guggenheim’s Structured Credit team performs rigorous research across the structured credit market and focuses on evaluating the structural features of each individual investment opportunity. Structured Credit team members have extensive experience originating, structuring, and managing securitizations and negotiating terms for our credit portfolio holdings. The Structured Credit team leverages the resources of our 20-person in-house legal team and the insight of our 120+ person Corporate Credit team, which is responsible for more than $75 billion in total corporate credit assets, including $16.5 billion in bank loans and $6.2 billion in CLOs. Guggenheim’s integrated resources deliver extensive research insights across a broad spectrum of the bank loan market, and the structuring and legal expertise necessary to uncover and understand the nuances of each individual CLO investment opportunity.
Scott Minerd, Chairman of Investments, Global CIO; Anne B. Walsh, JD, CFA, CIO, Fixed Income; Peter Van Gelderen, Co-Head, Structured Credit; Steve Brown, CFA, Portfolio Manager; Adam Bloch, Portfolio Manager
CLOs are complex investments and not suitable for all investors. Investors in CLOs generally receive payments that are part interest and part return of principal. These payments may vary based on the rate loans are repaid. Some CLOs may have structures that make their reaction to interest rates and other factors difficult to predict, make their prices volatile, and subject them to liquidity and valuation risk. Please see “Important Notes and Disclosures” at the end of this document for additional risk information.
This material is distributed or presented for informational or educational purposes only and should not be considered a recommendation of any particular security, strategy or investment product, or as investing advice of any kind. This material is not provided in a fiduciary capacity, may not be relied upon for or in connection with the making of investment decisions, and does not constitute a solicitation of an offer to buy or sell securities. The content contained herein is not intended to be and should not be construed as legal or tax advice and/or a legal opinion. Always consult a financial, tax and/or legal professional regarding your specific situation.
This material contains opinions of the author, but not necessarily those of Guggenheim Partners, LLC or its subsidiaries. The opinions contained herein are subject to change without notice. Forward looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. No part of this material may be reproduced or referred to in any form, without express written permission of Guggenheim Partners, LLC. The views and strategies described herein may not be suitable for all investors. All investments have inherent risks. An investment in CLO securities involves certain risks, including risks relating to the collateral securing the notes and risks relating to the structure of the notes and related arrangements. The collateral is subject to credit, liquidity and interest rate risk. Investing in bank loans involves particular risks. Bank loans may become nonperforming or impaired for a variety of reasons. Nonperforming or impaired loans may require substantial workout negotiations or restructuring that may entail, among other things, a substantial reduction in the interest rate and/or a substantial write-down of the principal of the loan. In addition, certain bank loans are highly customized and, thus, may not be purchased or sold as easily as publicly traded securities, Any secondary trading market also may be limited and there can be no assurance that an adequate degree of liquidity will be maintained. The transferability of certain bank loans may be restricted. Risks associated with bank loans include the fact that prepayments may generally occur at any time without premium or penalty.
Read a fund’s prospectus and summary prospectus (if available) carefully before investing. It contains the fund’s investment objectives, risks, charges, expenses and other information, which should be considered carefully before investing. Obtain a prospectus and summary prospectus (if available) at GuggenheimInvestments.com or call 800.820.0888.
©2019, Guggenheim Partners, LLC. All rights reserved. Guggenheim, Guggenheim Partners and Innovative Solutions. Enduring Values. are registered trademarks of Guggenheim Capital, LLC. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC.
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