TRUST AND AGENCY SERVICES
Collateralised loan obligations explained
31 August 2022
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
Collateralised 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.
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.
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:
- Senior secured bank loans to sub-investment grade corporates rated BB+ or lower; or else are
- Loans that yield over 125 basis points above a particular benchmark interest rate and which are also secured by a first or second lien
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:
- Bonds by maturity and risk; and
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 and a further diversified assets portfolio (subject to various tests and limitations to prevent high concentration or over exposure to certain sectors, for example).
The unique features, lifecycle, and advantages of CLOs
Whilst syndication and securitisation reduce lenders’ risk exposures, the issuance of a CLO provides investors with exposure to the underlying pool of corporate loans, enabling them to select securities within the CLO structure that match a risk-reward level of their own choosing.
Two key features of CLOs that distinguish them from other types of securitisations include the creation and life cycle of the CLO, and the involvement of a CLO manager in actively managing the CLO.
Lifecycle and structure of a CLO
A CLO manager establishes an SPV, and then creates a capital structure comprising various tranches, ranging from debt tranches rated AAA down to BB, with the sole equity tranche sitting below this (see Figure 1).
Having raised capital from investors, the CLO manager then participates in syndications, carefully researching and buying tranches of assets that match the risk-return expectations of their investors, known as the ‘warehouse period’. The ‘ramp-up period’ sees the CLO manager buy further assets using the issuance proceeds. The subsequent ‘reinvestment period’ sees the CLO manager trade assets (active management being a key distinguishing feature of this asset class, and is examined directly below), and the ‘post-reinvestment period’ or ‘amortisation period’ sees the CLO manager pay down the outstanding notes. Throughout the lifecycle of the CLO, interest and capital repayments received from the asset’s underlying obligors are then used to pay the CLO managers’ investors in line with the structure’s cash flow waterfall.
Figure 1: Typical CLO structure
Source: Deutsche Bank
Role of the CLO manager
Most securitised products are pooled by investment managers at two extremes, ranging from a static portfolio to a dynamic portfolio, the latter seeing new assets added to the portfolio only when other assets have had their principals redeemed. CLOs sit in the middle of this spectrum: their active management helps maintain (and can improve) the yield of the portfolio of loans within the CLO. The CLO manager will mitigate any risk to the overall structure by continually performing various coverage tests on the portfolio. This crucial mechanism allows the manager to identify and correct any deterioration to the collateral. If the coverage tests are not meeting the necessary requirements, cash flows will be redirected from the lowest debt and equity-tranche holders to the more senior holders within the capital stack. While the CLO manager will decide which trades to make, these will be undertaken by the collateral administrator.
Role of the collateral administrator and trustee
The role of the collateral administrator and the role of the trustee are typically carried out by the same firm. This is usually a large commercial bank like Deutsche Bank. The role of the trustee is to represent the noteholders in the transaction and to hold certain issuer covenants and the security package (for example, the accounts and loans) for the noteholders’ benefit. Should there be an event of default, the trustee can take control over the assets and bank accounts to protect the noteholder interests. If the CLO manager wants to change the terms of the CLO, then the trustee is there to represent the noteholders’ interests.
The role of the collateral administrator is vital to the day-to-day running of the CLO. It books and settles trades and acts as a check / balance on the manager’s obligations to act in accordance with the governing CLO documentation. It obtains valuations of the underlying assets, calculates, and performs compliance tests including performance and hypothetical trade testing, administers the bank accounts, makes payments and issues monthly investor and interest payment date reports on the underlying assets. It will work closely with the CLO manager to make certain the CLO has been managed according to the underlying documentation. It also provides an important role if the CLO hits an event of default as it will switch from taking direction from the CLO manager to running the CLO at the request of the trustee.
Benefits of CLOs
Thanks to the continuing improvements made from CLOs 1.0 to 3.0, CLOs today provide investors with several advantages.
They can offer higher returns (over the long-term) than other corporate debt types and can do so on a relative risk basis. The risk-reward balance is particularly favourable given the higher tranches in the CLO capital stack are typically over-collateralised, and today have both more stringent collateral eligibility requirements and higher levels of subordination. Higher subordination provides credit enhancement (that is, more protection should coverage tests or other performance tests not be met) to holders of senior debt tranches, for example by redirecting cash from debt tranches and equity.
The active management of CLOs allows (subject to the specified and fixed ‘reinvestment period’ and factors such as the prepayment of loans) trades to be made to further protect the portfolio from losses and/or enhance returns. The final returns of a CLO for investors are therefore impacted by the skill of the CLO manager at every stage of the life cycle, from structuring, analysis and selection of the credits, as well as in the active management of the portfolio. Even here, structural improvements brought in by CLO 2.0 have been made that enable the upside of active management while also providing safeguards, such as shorter call periods and shorter reinvestment periods.
Long-term capital in a vast (and growing) market
These structural protections have pulled new investors into the asset class, while regulatory protections (such as the demise of proprietary trading by investment banks) have pushed old categories of investors out of the asset class. The result is that the pre-financial crisis ‘hot money’ that could be found investing in CLOs has disappeared, replaced by a return of strong and stable investors with longer-term horizons, such as pension funds, insurance companies, private equity houses, and family offices.
CLO issuance, on the back of record levels of leveraged lending – hit record highs in 2021 in both the EU and the US (see Figures 2 and 3).
Figure 2: Annual EU CLO issuance
Source: Deutsche Bank Research
Figure 3: Annual US CLO issuance
Source: Deutsche Bank Research
Among the key regulations governing CLOs are:
- In the US, the Dodd-Frank Act (which implemented the Volcker Rule)
- In the EU, the Capital Requirements Regulation, the Securitisation Regulation, and the Alternative Investment Fund Managers Directive
It is worth noting that, although the UK has left the EU, its own regime closely follows that of the EU, which is becoming the global standard. These involve aspects such as whether high yield bonds can be included, and how (and how much) risk should be retained by lenders and CLO managers (so-called risk retention, the compromise reached being 5%, albeit with increased reporting requirements). Such reporting initiatives include those aspects of the ‘Simple, Transparent and Standardised’ (STS) criteria within the EU’s Securitisation Regulation which are applicable to CLOs.
On the subject of taxonomy challenges, from a somewhat slow start (the first CLO incorporating ‘ESG’ principles launched in 2018), ESG CLOs have become a very hot topic. A study by ratings agency Moody’s assessed that 85% of all new CLOs issued in Europe in 2020 and 2021 incorporated, explicitly or implicitly, sustainability factors. ESG definitions for investment purposes continue to evolve, although efforts are being made to standardise this through the EU Taxonomy Regulation, for example. This moving picture obviously also affects what is deemed an ESG-compliant approach to CLO investment itself, ranging from ‘light green’ CLO products which simply use industry-based negative screening at one end, through to ‘dark green’ CLOs at the other, which have sustainable investment as their core objective.
The CLO structure has proven itself having weathered the global financial crisis (GFC), and two subsequent down-cycles (if one factors in commodities and oil). Bar a slight pause in March 2021, as everyone tried to get their bearings, Covid caused barely a blip in the market’s demand, supply or functioning. While the market took a couple of years to recover from the GFC, it only took a couple of months to bounce back from Covid. Each such challenge, from the 2008 to 2021, has served to help tighten up the standardisation of CLO documents, creating a virtuous cycle which gives participants further comfort in the investment structure and market.
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