Collateralised Loan Obligations: Everything You Need To Know
Updated on: 19 Sep 2024
Published on: 22 Feb 2024
Collateralised loan obligations or CLOs, are an investment option that has the potential for higher returns. They are an alternative to corporate bonds and have a history of stable performance.
Read on to learn what CLOs are, their structure, process and more.
What are Collateralised Loan Obligations?
Here are some key points about CLOs:
CLOs are supported by a pool of loans, known as leveraged loans and bank loans.
A CLO pools payments of debts from the underlying loans and then distributes them to investors of different tranches.
These tranches are ranked based on the underlying loans’ creditworthiness.
Investors in the lower CLO tranches have the potential to earn high returns, but they also have a higher risk profile.
Here are the various tranches in a CLO:
Structure of a CLO
AAA Tranche
AA Tranche
A Tranche
BBB Tranche
BB Tranche
Equity Tranche
How are Collateralised Loan Obligations Created
Here is the process for creating CLOs:
Step 1: Decide the Capital Structure: The managers of CLOs decide the capital structure with different return and risk expectations.
Step 2: Raise Capital: Then, the CLO managers seek capital from investors to purchase loans underlying the security.
Step 3: Choose Tranches: The investors choose a tranche according to their return expectations and risk tolerance.
Step 4: Buy Loans: The managers of CLOs purchase loans with the raised capital.
Step 5: Create Special Purpose Vehicle (SPV): SPVs are created for issuing the CLOs to the investors.
Step 6: Repay the Investors: CLOs will start paying the investors according to their tranches.
Step 7: Termination: After the repayment of all the securities and loans, the CLOs will be terminated.
Higher Returns: CLOs provide higher returns than other fixed-income investments because the underlying loans are riskier as they are offered to non-investment grade borrowers.
Portfolio Diversification: CLOs also offer a higher exposure to diversified loans made towards non-investment grade borrowers, which helps reduce the default risk.
Enhanced Liquidity: CLOs offer more liquidity as compared to the underlying loans since they can be easily traded in the secondary market.
Professional Management: These securities are professionally managed by experienced CLO managers who make decisions with the intent to get higher returns while reducing the risk.
Credit Enhancement: CLOs have various tranches according to different credit risk levels. This offers additional protection against losses that can occur due to defaults in the underlying loans.
Risks of Collateralised Loan Obligations
These come with the following risks:
Credit Risk: The underlying loans in CLOs have high credit risk and since these loans are given to non-investment grade borrowers, there are high chances of default. A high number of defaults can lead to significant losses.
Interest Rate Risk: CLOs are structured like fixed-income securities having a set rate of interest. If the interest rate increases, the securities’ value may go down.
Prepayment Risk: The borrower can pay off the underlying loan earlier, which can decrease the potential returns of CLO investors, especially if they are expecting a particular interest income in the long run.
Residual Liquidity Risk: It may be hard to get buyers for CLO securities when the market is unstable, making it difficult to sell investments or exit from the positions.
Complex Investment Vehicle: Since there are different tranches, risk levels and payment structures in CLOs, it can be difficult to understand the associated risks and make the right investment decisions.
Now that you know the CLO meaning, benefits, risks and more, you can explore this investment avenue to get potential returns. In case you need funds for investments or financial emergencies, you can get up to ₹5 lakhs with an Instant Personal Loan from Fibe.
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FAQs on Collateralised Loan Obligations (CLOs)
What are collateralised loan obligations in simple terms?
CLOs are securities supported by a collection of loans. In simple words, they are repackaged loans that investors purchase.
What is an example of a collateralised obligation?
Consider this collateralised loan obligation example: A company approached a bank to borrow ₹100 crores. The bank will approve the loan but will reduce its risk by looking for other lenders to contribute to the loan. The lender purchasing these loans will be the CLO manager and other lenders pooling into it will be the investors.
