The structure of a CLO (Collateralized Loan Obligation) is similar to a company'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 lower 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 loans. The loan diversification in various industry groups results in a lower correlation with other market risks (please refer to 4. Correlations and Decorrelations).

The liability side of the balance sheet is structured into tranches rated AAA to the lowest rated tranche BB or even 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 rated tranches the coupon rate is fixed at issuance till the end of the non-call period. After serving interest and / or principal the remaining cash flow is distributed to the equity tranche. Since the equity tranche is the unrated first loss piece and hence carries the highest risk, it may receive a higher return (subject to CLO manager quality / Alpha).
The CLO asset side contains loans rated BB+ or lower, whereas up to 70% of the CLO liability side consists of an AAA component. This loan arbitrage is the reason for a cost-effective portfolio funding.

The liabilities of a CLO have a longer maturity than the asset side; therefore, the manager has to reinvest in order to match the maturity profiles. There is a pre-set reinvestment period, hereafter 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 a reference rate. Hence, the structure has a respectively low interest rate risk.

• Simultaneously, the investment bank markets the liabilities (please refer to 1.1 What is a CLO?) to institutional qualified investors. At pricing, the exact sizes of the tranches as well as their spreads are fixed. At settlement (closing date) the rated tranches and the equity tranche are paid for by the investors. The proceeds are used to purchase the portfolio for the SPV and to create the asset base / collateral of the 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 duties of the trustee, the flexibility of the CLO manager after the reinvestment period, the length of the reinvestment period, the auditor as well as the rights of the funding tranches.

• Issuing documents are unique, due to timing, market environment, choice of lawyers as well as investor demand.

In order to properly understand the seniority of loans, a look at the capital structure of a company is helpful:

After the reinvestment period (usually 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 tranches in the order of rating seniority. Subject to market conditions, the CLO 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 payments is the equity of the SPV.

In the world of securitization, the waterfall principle describes the subordination nature of various funding tranches according to their rating-based seniority. Payments of interest and principal will first serve the most senior rated tranche (AAA). After completely serving the most senior tranche, the next subordinated tranche (AA) will receive payments and so on. This approach is used all the way down to the unrated tranche, the CLO equity tranche.

Losses are allocated using the reverse waterfall principle whereas interest and capital losses are first absorbed by the lowest tranche or first loss piece (equity) until this tranche is completely absorbed, followed by the more senior tranches above (B, BB, BBB).

CLOs by nature are Asset Backed Securities (ABS). The asset side of ABS structures are generally a pool of claims. Due to the large size and high diversification the pools tend to be static. For this reason, the lowest rated or unrated tranche will not carry any Alpha component and may only perform due to good selection or timing of the pool. In this respect CLOs are different because the portfolio of senior secured loans is actively managed and carry for this reason a (sometimes significant) Alpha component. The difference of CLOs issued in the same year under similar market conditions with the same reinvestment period may be very large. 2.1 Management of a CLO) and carry significant alpha components because of management performance. The difference between an above-average and a below-average CLO, emmitted in the same year, with the same reinvestment period, can be significant.

• 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;

• Loan selection and investment process (relative value strategies / loan spreads);

• Historical default rates, diversification and quality of covenants;

• Interest and cash flow development within the CLOs under management;

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

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

• Successful investment of prepayments;

• Is the CLO manager invested in the CLO (alignment of interest)?

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

• Average experience of the individual, the team and turnover within the team;

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

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

European investors face currency risk if they happen to invest in U.S. Dollar denominated CLOs.

Unpredictable risks called „black swans" cannot be foreseen, calculated or hedged. An example for such a risk is 9/11 (World Trade Center attack), which sent the markets into turmoil.

Entering a CLO position the investor purchases the ability of the management to run the portfolio according to their track record as well as the experience of the CLO manager team. Consequently, a change in the key personnel of the CLO manager might result in a significant change of the risk profile.

Human error may occur in multiple ways. Examples are buying instead of selling or vice versa, mistakenly selling the portfolio or parts of it or booking an erroneous transaction.

Fraud is very difficult to detect. The securitized credits of the investment portfolio are subject to fraud risks. These may occur on the part of both the obligor and the CLO manager.

According to S&P Global Ratings, from 1994 to 2019 only 0.4% of CLOs rated by S&P defaulted, i.e. of the 13,430 CLO tranches rated by S&P since 1994, 58 CLO tranches defaulted. Drivers for the losses were positions in subordinated corporate bonds with fixed coupons that suffered large losses in the years from 2000 to 2002. Moreover, the discrepancy between an exposure of 15% to 30% to fixed rate assets on the CLO asset side versus a floating rate CLO liability side, deteriorated the situation further in the rising interest rate environment.

Those factors have been largely eliminated in today's 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 flexibility 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 are defined as the spread between a “riskless" investment and a risky investment. From the beginning to the peak of the Great Financial Crisis (2007 - 2009), the risk premium increased significantly in all CLO tranches. This clearly illustrates the liquidity bottleneck and the aversion of investors and traders to take any kind of risk.

The historical average risk premia imply a higher default rate than actually occurred. Default rates depict just one factor of the risk premia consisting among other things out of illiquidity, rating etc. This is shown in the charts below. Currently, the highest risk premia are earned by intentionally taking an illiquid position.

In order to clarify the correlations, we are showing three different timelines: