The CLO


This page and the information contained herein caters for institutional investors only who would like to inform themselves about risk and illiquidity of CLOs.
In the following chapters we will try to create an understanding for the three factors of risk premia: Illiquidity, default risk as well as premia for sub-investment grade credit. These factors are the drivers behind a CLO position.

The structure of a CLO is similar to a bank's balance sheet with the difference that only one portfolio is managed within a Special Purpose Vehicle. CLOs have been issued since the early 1990s.

THE ASSET SIDE contains a pool of debt, often comprising of low rated corporate loans. The portfolio is managed by a team of experienced credit specialists who are usually divided into industry groups and analyse the development of various corporations within their universe of industries. The result of the analysis is the asset allocation (purchase of loans) or the sale of riskier credits. The diversification of a portfolio containing secured loans in various industry groups results in a lower correlation with other market risks (see 4.2 Correlation Matrix)

THE LIABILITY SIDE of the balance sheet is structured into tranches rated AAA down to the lowest rated tranche B. The equity of the SPV is unrated. Earnings from the portfolio are distributed according to the waterfall principle, meaning interest and principal are first distributed to the most senior tranche (AAA), thereafter to the tranches below, giving priority according to the rating. For all tranches the coupon rate is fixed at issuance. After serving interest and /or principal the remaining cash flow is distributed to the equity. The equity carries the highest risk (being the first loss piece and unrated) but - carrying an Alpha component - may receive (subject to CLO manager quality) a high return.

The Asset side contains loans rated BB+ or lower, the liability side has an up to a 70% AAA component. This credit arbitrage is the reason for a very cost effective funding of a portfolio.

The Liabilities of a CLO have a longer maturity than the Asset side, therefore the Manager has to reinvest in order to match maturity profiles. There is a set reinvestment period after which prepayments and maturing loans will be used to pay down the Liabilities.

Assets as well as liabilities are generally both priced at a spread over 3 month LIBOR so the structure has a low interest rate risk.

The graphical representation of a special purpose vehicle - CLO

Graph for illustration purpose only
Source: CIS

Construction

  • Prior to establishing a CLO an investment bank starts to purchase and "warehouse" loans (under the CLO mangers guidance) so when the CLO is launched there is already a carefully selected portfolio of loans ready to be purchased by the CLO. If the portfolio purchased doesn't represent 100% investment of the portfolio the CLO manager continues to acquire loans directly in the market.

  • Similarly the investment bank markets the liabilities (please see What is a CLO) to institutional investors. At pricing the exact sizes of the tranches as well as their spreads are fixed. At settlement (closing date) the liabilities and equity are paid for by the investors. The proceeds are used to purchase the portfolio for the SPV and to create the asset base of the CLO.

Legal basis of a CLO

  • A CLO is incorporated within a Special Purpose Vehicle. It has a certificate of incorporation, memorandum and articles and most importantly the private placement memorandum (PPM). This issuing document is the basis to fund the asset side of the CLO structure. After settling the liabilities and the equity to purchase and transfer the portfolio to the CLO, the SPV functions like a normal company. The issuing document also defines the rating methodology for the individual tranches, the tasks of the trustee, the freedom of the manager to transact after the reinvestment period, the length of the reinvestment period, the auditor as well as the rights of the funding tranches.

  • There is no issuing document that equals another because timing, market environment, choice of lawyers as well as investor demands are drivers for various components of the document.

A senior loan holder has a legal claim to the borrower's assets above all other debt obligations. The loan is considered senior to all other claims against the borrower so in the event of bankruptcy the senior loan is the first to be repaid before all other interested parties.

Seniority

  • Senior secured loans are issued as first lien or second lien. They rank senior in the capital structure to unsecured debt and equity capital.

  • Covenants provide additional protection by setting limits on leverage and interest coverage ratios.

Default Losses

  • Default rates of senior secured loans were historically on average 2.7%, compared to 3.5% with high yield bonds.*

  • Recovery rates of senior secured loans were historically 65%, compared to 46.1% with high yield bonds.*

Maturity

  • The original maturity of senior secured loans is usually around 5 or 10 years.

  • Prepayments reduce the average maturity to around 2 to 3 years.

Coupon

  • Coupons of senior secured loans are usually floating based on Libor, with or without cap or floor.

  • Senior secured loans have low sensitivity to changes in interest rates (low interest rate duration), but high sensitivity to widening or tightening credit spreads (high credit spread duration).

Loan Bond
Rating sub-investment grade sub-investment grade
Rank senior secured senior unsecured
Covenants e.g. debts limits,
interest coverage
None
Default Rates* 2.7 percent 3.5 percent
Recovery Rates* 65 percent 46.1 percent
Legal Maturity 5-7 years 5-10 years
Expected Maturity 2-3 years 2-4 years
Other Optionalities prepayments / cancellation rights None
Coupon Floating Fixed
Disclosures Monthly Quarterly

For illustration purpose only
* Credit Suisse 1995-2015

Source: Credit Suisse / LPC / Data 09-30-2015

Source: Credit Suisse / LPC / Data 09-30-2015

Market Depth

  • Syndication of senior secured loans to institutional investors is more advanced in the US than in Europe. In the US more than 46% of all loans were syndicated, vs. 35% in Europe.
  • There are 5 times more outstanding syndicated loans in the US ($949bn) than in Europe ($153bn).

Bankruptcy Code

  • In the US, there is a uniform bankruptcy code ("Chapter 11") across all 50 states.
  • In Europe, there is no uniform bankruptcy code across 28 countries.

Diversification

  • Comparing number of debtors on an industry category basis, the categories with the least numbers in the US contain 45 debitors, vs. Europe with 3 debitors.
  • On average, industry categories in the US contain 66 debtors, vs. Europe with 12 debtors.

The US leveraged loan universe is the least volatile and for this reason used for CLOs.

Source: Credit Suisse

The purpose of a CLO is to create high returns using a sub-investment grade senior secured corporate loan portfolio to satisfy high return demands of risk taking investors as well as being able to structure a CLO in a manner that most tranches sold to investors will carry an investment grade rating.

After purchasing the portfolio from the investment bank, it will be actively managed under a strict set of criteria which is set at the launch of the CLO. Prepayments will be reinvested, defaults will be restructured or liquidated until a recovery is paid and credits creating a problem will be sold and replaced.

The active management of the portfolio is terminated at the end of the reinvestment period. Thereafter the freedom of management may be severely reduced to monitor and sell credits but usually not reinvest loans due and prepayments.

The trustee provides monthly reporting for all investors giving details of the portfolio and all statistics and covenants needed to maintain rating for the liabilities.

After the reinvestment period (currently 4 to 5 years after origination) prepayments as well as loans due will not be reinvested. Funds available will be used to pay down the liability structure of the SPV starting with the most senior tranche followed by the mezzanine in the order of seniority in rating.

Subject to market conditions the manager may at any time after the reinvestment period with the consent of the senior tranche (if it is still outstanding) and the equity call the transaction, meaning all assets will be auctioned, the liabilities will be paid down and the SPV will be closed if all assets are liquidated. The last tranche receiving down payments is the equity of the SPV.

For illustration purposes only

The waterfall principle describes in the world of securitization the subordination nature of various funding tranches according to their seniority in rating. Within a pool payments of interest and principal will first serve the most senior rated tranche (AAA). After serving the senior tranche fully the next subordinated tranche (AA) will receive payments etc.. This principal is used all the way down to the unrated tranche, the equity.

Losses are allocated using the reverse waterfall principal whereas interest and capital losses are first absorbed by the lowest tranche or first loss piece (equity) until this tranche is fully lost, thereafter by the tranche (B, BB, BBB) above etc..

Example of Waterfall Principle for a quarterly interest distribution

For illustration purposes only

Manager skills that may be responsible for small, large or very large difference in manager performance and hence are an important factor in manager selection.

  • Existing track record lasting over various economic and credit cycles

  • Focus and specialization on industry groups and regions (Know how and value drivers)

  • Team structure and processes as well as focus on key personnel

  • Credit selection and investment process (relative value strategies/ credit spreads)

  • Historical default rates, diversification and quality of covenants

  • Interest and cash flow development within the CLOs under management

  • Risk management, risk structure and liquidity steering (economic cycles)

  • Timing, portfolio building and management (position in economic and credit cycle)

  • Successful investment of prepayments

  • Is the fund manager investing in the CLO, if so to what extent

  • Checking covenant clauses as well as the CLO's portfolio to empower its rights

  • Average experience of the individual, the team and fluctuations in the team

In the graph below we show CLOs originated in the same year under equal market conditions managed by different CLO managers (split in the best 95th percentile and 50th percentile as well as the lower 25th and 5th percentile).

Source: CIS, Intex

Default Risk:

Every credit secured or unsecured carries default risk. Usually secured loans have a higher recovery rate than unsecured bonds and hence tend to be more stable. There are however industries where even a secured loan does not give sufficient loss protection.

Liquidity Risk:

The lower the tranche the CLO the investor is invested in the higher the illiquidity. Investing in the lower or lowest tranche may result in holding the tranche to maturity in the worst case. It is also possible that market conditions and pricing of tranches may not reflect their real intrinsic value due to high illiquidity premia.

Currency Risk:

European investors face currency risk if they happen to invest in USD denominated CLOs. Event Risk:

Unpredictable risks called „black swans" can not be foreseen, calculated or hedged. An example for such a risk is 9/11 (world trade center attack), which sent the markets into turmoil.

Personnel Risk:

Entering a CLO position the investor purchases the management ability to run the portfolio according to their track record as well as with the experience the team has built over time. If individuals of management or of the senior analyst team decide to leave for whatever reason the risk entered into buying the position may change significantly.

Human Error:

Human error may occur in multiple ways, Buying instead of selling or vice versa, mistakenly selling the entire or part of the portfolio (this really has happened) or booking a transaction wrong in error.

Fraud:

Fraud is very difficult to detect. Fraud on the highest level occurred at an energy company named Enron which had loans and bonds outstanding. The loans were secured by their own stock. The company changed their business model, was fraudulently managed and went into insolvency. Recoveries were low.


All risks or a combination of the risks described below may result in severe capital losses or even a total capital loss.

Of 4118 tranches rated by Moody's from 1996 in 719 US CLOs only 32 tranches from 14 CLOs experiences losses at maturity. Drivers for the losses were positions in subordinated corporate bonds with fixed coupons that suffered large losses in the years 2000 to 2002. Additionally, a weighting of 15% to 30% of fixed rate assets facing rising interest rates, but being funded with floating liabilities created a harmful situation.

Such factors have been largely eliminated in today's US CLO structures. Since 2013 it is rare for a CLO to be permitted to hold any bond positions (in some structures there is still some freedom to buy corporate bonds but this is limited to between 5% and 7%). Furthermore any fixed rate exposure within a CLO is hedged to protect against movement in interest rates.

Risk premia is defined as the spread between a riskless investment and a risky investment. CLO 1.0 were the first CLOs coming to market and gave management a lot of freedom to transact and to be active after the reinvestment period. Risk premia in liability tranches increased significantly from the beginning to the peak of the crises 2007 - 2009. This mirrors the dramatic loss of liquidity as well as the unwillingness of traders and investors to take any position.

Source: Wells Fargo

2.0 CLOs after the crisis showed a normal development without any exaggerations.

Source: Wells Fargo

Source: Credit Suisse

Source: Moody's

The historical average of risk premia always implies a higher default rate than actually occurs. This is because default rates are only one factor with other factors such as illiquidity, rating etc contributing to it. This is shown in the chart below. Currently the highest risk premia is earned by intentionally taking an illiquid position.

Source: Credit Suisse

To clarify existing correlations we are showing two time lines:

2002 to 2007 (after Dotcom to pre crisis)

CLO Eq Nav CLO Eq TR CSHF HFRI HFRX LPX50 Preqln
S&P500 20 70 50 70 60 70 50
Russell 2000 10 80 60 80 70 80 30
VIX 10 50 30 40 40 40 10
CS HY 20 90 50 50 50 60 10
CL LevLoans 20 90 30 30 40 40 20
Converts 20 90 60 70 70 60 70
CD X 0 90 50 50 60 70 30
CD X HY 10 90 50 50 60 70 10
EURUSD 10 10 50 30 30 30 10
GBPUSD 0 30 40 20 20 30 10
USDCHF 0 20 30 20 20 20 30
USDJPY 10 50 10 10 0 10 30
Gold 20 10 50 40 40 30 10
Oil 20 60 10 10 0 10 10
10y UST 20 30 0 10 0 0 30
UST Slope 20 50 0 10 10 0 20

2007 to 2012 (during and after the crisis)

CLO Eq Nav CLO Eq TR CSHF HFRI HFRX LPX50 Preqln
S&P500 0 50 70 80 70 90 30
Russell 2000 0 50 70 80 70 90 20
VIX 20 30 60 70 60 50 20
CS HY 10 60 70 70 80 80 30
CL LevLoans 10 60 70 70 80 70 70
Converts 10 40 70 80 70 70 20
CD X 20 40 60 70 50 70 10
CD X HY 10 40 50 70 50 80 10
EURUSD 10 20 50 60 50 60 20
GBPUSD 10 40 60 60 60 60 50
USDCHF 0 10 40 40 30 40 20
USDJPY 10 30 20 20 30 20 40
Gold 10 20 30 30 30 10 10
Oil 0 50 70 80 80 50 50
10y UST 20 20 40 40 40 30 70
UST Slope 20 10 10 0 10 10 40

[1] The HFRX Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe. It is comprised of all eligible hedge fund strategies; including but not limited to convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merger arbitrage, and relative value arbitrage. The strategies are asset weighted based on the distribution of assets in the hedge fund industry.

[2] The LPX50 is a global index that consists of the 50 largest liquid LPE companies covered by LPX.

[3] The CLO Equity Index (TR) is composed of two different series. Firstly, a time series of the equity trading prices based on a JP Morgan research. Secondly, a time series depicting the actual cash flows of Eagle Investment Monitor since 2006.

The colour coding depicts that stocks have a self explanatory high correlation whereas goods and interests play a minor role – if any at all. Further, it is recognizable that the correlation between hedge funds and capital market investments increased whereas the correlation to CLO equity decreased.