Breaking Down a CLO’s Lifecycle
CLO Lifecycle: CLOs typically last eight to 10 years, during which time a series of milestones are passed.
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 concludes at 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. At that point, investors in the equity tranche of the CLO can refinance the CLO.
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 CLO debt. The amortization period represents the end of a CLO’s lifecycle.
Investing in CLOs
CLOs have several features that make them an integral component of Guggenheim’s fixed-income strategies. In addition to their investor-friendly structural protections and historical credit performance, one of the most important characteristics of CLOs is their floating-rate coupon, which helps insulate bond prices from rising interest rates. Fixed-rate securities decline in value as interest rates rise and investors discount the value of the fixed-rate bonds’ relatively low 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 mark-to-market risk, and the basic architecture of CLOs requires that investors must 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 simultaneously considers potential returns relative to other securitized and corporate fixed-income sectors as well as its pricing relative to other short-duration options.
Capturing opportunities in the CLO market requires the expertise to perform bottom-up research on individual bank loans in the underlying collateral pool. Because CLOs routinely have over 200 issuers in their collateral pools, investment managers must have significant corporate credit research capabilities to fully evaluate the underlying credit risk in each CLO.
The importance of understanding a CLO’s structural characteristics cannot be underestimated. Two CLOs with the identical collateral assets may perform differently due to structural differences. The legal documentation that governs a typical CLO can be in excess of 300 pages, and a high degree of expertise and consistent market presence are required to analyze these documents and discuss key terms with managers looking to access the market. The ability to access the value in CLOs becomes available to investors with the appropriate mix of credit research, structuring experience, and legal expertise.
Important Notices and Disclosures
1. Source: Guggenheim Investments, SIFMA, JP Morgan, Bank of America. Data as of 6.30.2022. 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 at which 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.
Glossary of Terms
Basis Point: A unit of measure used to describe the percentage changes in the value or rate of an instrument. One basis point is equivalent to 0.01 percent.
First Lien: A security interest in one or more assets that lenders hold in exchange for secured debt financing. The first lien to be recorded is paid first.
Mark-to-Market: A measure of the fair value of an asset or liability, based on current market price.
Mezzanine Financing: A hybrid of debt and equity financing that is typically used in the expansion of existing companies.
Second Lien: Debts that are subordinate to the rights of more senior debts issued against the same collateral or portions of the same collateral.
Secured Overnight Financing Rate (SOFR): A broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.
Structured Investment Vehicles: Pools of investment assets that attempt to profit from credit spreads between short-term debt and long-term structured finance products such as asset-backed securities.
Tranche: Related securities that are portions of a deal or structured financing, but have different risks, return potential and/or maturities.
Waterfall: A hierarchy establishing the order in which funds are to be distributed.
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This material contains opinions of the author or speaker, 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.
Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy or, nor liability for, decisions based on such information.
Investing involves risk, including the possible loss of principal. Investments in bonds and other fixed-income instruments are subject to the possibility that interest rates could rise, causing their value to decline. Investors in asset-backed securities, including mortgage-backed securities, collateralized loan obligations (CLOs), and other structured finance investments generally receive payments that are part interest and part return of principal. These payments may vary based on the rate at which the underlying borrowers pay off their loans. Some asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, causing their prices to be volatile. These instruments are particularly subject to interest rate, credit and liquidity and valuation risks. High-yield bonds may present additional risks because these securities may be less liquid, and therefore more difficult to value accurately and sell at an advantageous price or time, and present more credit risk than investment grade bonds. The price of high yield securities tends to be subject to greater volatility due to issuer-specific operating results and outlook and to real or perceived adverse economic and competitive industry conditions. Bank loans, including loan syndicates and other direct lending opportunities, involve special types of risks, including credit risk, interest rate risk, counterparty risk and prepayment risk. Loans may offer a fixed or floating interest rate. Loans are often generally below investment grade, may be unrated, and can be difficult to value accurately and may be more susceptible to liquidity risk than fixed-income instruments of similar credit quality and/or maturity. Municipal bonds may be subject to credit, interest, prepayment, liquidity, and valuation risks. In addition, municipal securities can be affected by unfavorable legislative or political developments and adverse changes in the economic and fiscal conditions of state and municipal issuers or the federal government in case it provides financial support to such issuers. A company’s preferred stock generally pays dividends only after the company makes required payments to holders of its bonds and other debt. For this reason, the value of preferred stock will usually react more strongly than bonds and other debt to actual or perceived changes in the company’s financial condition or prospects.
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