What Is a Collateralized Loan Obligation?
A collateralized loan obligation or CLO refers to a security that is backed by a pool of loans. It’s a portfolio of leveraged loans, those extended to companies and individuals already in debt, that is securitized and managed as a fund. Securitization simply means converting an asset, a loan in this case, into marketable securities. The purpose is to raise cash by selling them to other investors. And this is possible because all financial assets can be turned into items of value. CLOs are quite similar to collateralized mortgage obligations or CMO. But a different type of debt is involved in this case – a company loan and not a mortgage.
How Collateralized Loan Obligations Work
A CLO manager acquires loans and puts multiple of them together. The CLO manager sells stakes in the CLO to other investors in various tranches to purchase new debts. A tranche simply refers to one of several related securities offered in the same transaction. In other words, it’s a portion of a pool. Being the first in line to risk losing money if the businesses fail to repay the purchased loans can come with larger yields. The loans are often risky because they’re given to companies that already owe an amount of money that is above average for their size and business type.
The concept of CLOs is to increase the supply of willing business lenders and lower the interest costs of loans given to businesses. Also, CLOs allow banks to sell loans to outside investors right away. This approach enhances the borrowing experience for businesses and the lending experiences for the banks. The tranche structure enables CLOs to bundle multiple loans without equally transmitting the loan payments to CLO owners. This is unlike the usual lending process in which a lender can earn a fixed interest rate but with the risk of losing money if a business doesn’t pay back. So, CLOs help corporations without good credit to borrow from lenders other than banks and lower their cost of borrowing.
The Pros of Collateralized Loan Obligations
There are several benefits to being the investor of a CLO:
- Higher returns: CLOs usually bring in higher returns than other categories of corporate debt like investment grade bonds, high yield bonds, and bank loans.
- Wider yield spread: CLOs have lower liquidity and regulatory requirements than other debt instruments like corporate bonds. This makes their yield wider too.
- A good risk profile: CLOs can have lesser risks than other corporate debt types because of factors like the default rate, recovery rate, and maturity time.
What You Should Consider Before Taking Collateralized Loan Obligations
CLOs can be a risk to investors in the following ways:
- Credit risk: Because the leveraged loans are offered to companies that already owe more than they should be, there’s some credit risk
- Collateral deterioration: In case of a loss, cash flow is allocated to tranches depending on seniority. So, the junior tranches may lose principal.
If you have any doubts about which type of loan you should take out for your business, do not hesitate to contact our experts at Blursoft!
