COLLATERALISED LOANS
Collateralised loan obligations explained
Against a backdrop of geopolitical and economic volatility, collateralised loan obligations (CLOs) continue to navigate uncertainty and hold net asset values. flow explains the role of this remarkable asset class in Deutsche Bank’s Trust and Agency Services portfolio
C
ollateralised loan obligations (CLOs) sit at the pinnacle of various financial processes, in terms of both
their sophistication and magnitude. CLO managers buy half of all leveraged loans issued, more than any single counterparty demographic, and for this reason are a vital component of the loan markets. This article unpacks CLOs, examining their building blocks, context, magnitude, merits, processes and prospects.
Syndication and securitisation framework The key role for a bank (or lender) is to recycle capital efficiently, safeguarding capital for, and providing returns to, its investors, while also providing investment opportunities for others. A variety of financial mechanisms build upon each other to finesse the efficiency of this process, thereby enhancing capital provision, security and returns for the stakeholders involved. In this process, syndication is progressed by securitisation, which comes to life through CLOs.
Syndication Syndicated loans see a group of lenders pool their resources to make a loan to borrowers, who are usually privately held companies, but sometimes also a special purpose vehicle (SPV) relating to a project. This both enables borrowers to raise greater sums and lenders to reduce their risk exposure. The syndicate of lenders will include the originator bank and will have the relationship with the underlying corporate. However the syndicate will also include other banks, funds and other participants.
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Such syndication can occur regarding loans to investment-grade borrowers; but it also occurs regarding leveraged loans – both those which are ‘broadly syndicated loans’ (the most common form of leveraged loan) as well as those made to the mid-market. Leveraged loans are typically defined as:
1.Senior secured bank loans to sub- investment-grade corporates rated BB+ or lower; or else are
2.Loans that yield over 125 basis points above a particular benchmark interest rate and which are also secured by a first or second lien
Securitisation Taking syndication a step further, securitisation merges the worlds of credit markets and capital markets, and in the process achieves a number of goals for both lenders and investors. Securitisation is the process of converting such loans into marketable securities, which can then be sold to investors. These marketable securities are ‘structured credits’, and thus are a sub-type of fixed-income securities. CLOs, like other structured credits, fulfil
this securitisation process by organising, pooling and structuring the syndicated collateral (in the case of CLOs, loans) into a single security, and then issuing to investors tranches of:
1. Bonds by maturity and risk; and 2. Equity
Leveraged loans are well suited for securitisation. This is because they pay
regular income into the CLO and, given the large number of borrowers participating in the leveraged loans space, also provide a diverse source of assets for the CLO manager to choose from.
Function of CLOs The main aim of CLOs is therefore to take loans (syndicated and/or leveraged) made to corporate or private equity borrowers, and to securitise them by slicing them up into ‘tranches’ of interest-paying bonds, thereby redistributing them from the lenders’ balance sheets to investors. These CLO pools are considerable, comprising typically 150 to 250 loans. Economically, holders of debt tranches are providing term-financing for the pools, whereas the equity investors own the managed pool – and therefore bear the upside but also the downside and default risk of the underlying loans. Most CLOs are ‘arbitrage CLOs’, which try to capture the excess between (a) money coming from payments relating to the interest and principal on the underlying loans, and (b) money going out on costs, management fees, etc. The second type of CLOs are ‘balance sheet CLOs’, which are as the name suggests.
A history of investor-friendly innovation CLOs have certainly evolved since the pre- 2008 transactions (known as a CLO 1.0) and the direction of travel has generally been to enhance investors’ protections and interests. After the 2008 financial crisis, notable developments in the more recent versions (CLO 2.0 and 3.0) have included increased credit support, Volcker rule compliance
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