Collateralized Loan Obligation (CLO)
Candlefocus EditorThe structure of a CLO is usually as follows: A capital stack is created by pooling together debt from a variety of borrowers into one security. The debt is then divided into “tranches”. The asset manager behind the CLO creates a layer of protection by assigning each tranche seniority of payment priority. The higher-ranking tranches, i.e., senior tranches, are the first to receive support from the incoming payments while the lower-ranking, or junior tranches, bear the risk of default first.
The structure of the capital stack can be different but most often are composed of three levels: Equity, Senior and junior bonds. The equity is the riskiest part of the capital stack which participates in the losses first and its reward is the highest. Senior bonds are the most secure portion of the capital stack as they get repaid first, but the returns are lower. Junior bonds have the highest returns but also the highest risk of default, as the first to feel the impact of any credit losses.
The purpose of the capital stack is to provide investors with a wide range of risk-reward profiles. By allocating different risk elements between tranches, the asset manager creates a security with the potential to offer higher yields and a lower cost of capital. The capital stack provides investors the ability to take advantage of their individual risk-reward preference, such as equity investors who are willing to take a higher risk to get a higher return.
In addition to the capital stack, collateralized loan obligations also have an additional feature that adds to their value for investors: A Debt Service Reserve Account (DSRA). This is a cash buffer set aside by the asset manager to cover potential defaults and protect the remaining investors from losses. It helps to reduce credit losses from an unexpected event and creates a higher degree of credit protection for investors.
Collateralized loan obligations have become a popular way for investors to achieve target return objectives in an ever changing market environment. CLOs offer the potential for high yields and strong credit protection for investors due to the structures’ asset selection and tranching mechanism. In addition, the DSRA improves credit protection and loss absorption capacity of the CLO, creating an attractive investment option in today’s market.