Susan Kelly
Jun 11, 2022
Do you think your home or car loan is a "straight line" debt? If so, then you are in for a surprise. Sometimes, when you borrow money from your bank or credit card company to finance the purchase of something such as a home, they may require the asset purchased to be used as collateral. This is referred to as a straight-line transaction.
However, sometimes it may not be possible for an individual to use their home or car as collateral. This is where a Collateralized Loan Obligation (CLO) comes into play.
A financial product is held by a group of investors instead of one individual, the home or car owners. The traditional collateral used in the funding of a loan is usually property. Still, if this is not possible, these banks and investment fund managers will use other forms of collateral, such as cash and stocks. These are all known as "collateralized" products. The CLO will be reduced to zero when the original loan has been paid back over time.
The benefit for the bank is that they can source cheap money and have a steady cash flow each month, which reflects on their lending to homebuyers or car buyers. Rather than take out a traditional mortgage or car loan, consumers can opt for a CLO.
Collateralized loan obligation (CLO) may be backed by corporate loans, asset-backed securities, commercial mortgages, and/or auto loans. So, in essence, they are debt obligations, just like bonds. The unique thing about these instruments is that they are sold the same way as government bonds to investors worldwide who will receive regular interest and principal payments on the loan over time.
A CLO is issued to an investor who purchases them through tradable certificates. The investor then has the option to either sell the certificates or hold them until maturity. The lender uses investment banks to create a pool of money which is then structured into CLOs, and the funds are made available to investors. These CLOs are usually low-basis instruments and may have a 3-5 year maturities.
There are many advantages for investors to investing in a CLO, including:
It is safe for investors as these instruments are secured against various types of collateral, such as corporate loans, asset-backed securities, commercial mortgages, or auto loans, and so are not subject to default risk like mortgage securities.
If an investment bank or CLO manager decides to choose an investment strategy that is not financially sound, they must still be backed by a high-quality corporate loan or asset-backed security, so their ability to pay out investors is guaranteed.
Investors are paid a fixed interest rate on the money invested in these instruments. If the instruments have a higher yield than the market rate for similar instruments, there may be a profit potential.
However, as with any risky trading venture, there is a risk of losing all capital invested. CLOs are considered hybrid securities because they are similar to bonds and stocks. They trade like stocks but provide returns like bonds.
So, the most significant risk for investors is that the value of these instruments may fall, so they may not be able to recoup their initial investment.
There are different types of CLOs, including:
These typically have a higher rate of return than other loans. However, they only loan money to companies with a credit rating of BBB- or above. This means they are considered "investment grade" and therefore a low risk to lenders. Collateral: corporate loans.
These types of CLO hold assets that are bundled together and then sold to investors. The collateral comes from receivables such as auto loans, credit cards, student loans, and mortgages. Investors receive payments based on the cash flow generated by the underlying assets; these payments may include principal, interest, or both depending on whether the investor is buying a senior or equity security. Collateral: asset-backed securities.
Commercial mortgages are used as collateral for these types of CLO and thus have a high repayment rate because they have low default risk. Collateral: commercial mortgage securities.
Recently the mortgage-backed securities CLO market has begun to experience significant losses because of volatility in the US housing market and an increase in default rates. Auto loans are considered a less risky source of collateral as they have lower default rates and improved conditions in recent years. Many car companies are now within the credit rating sector, considered investment grade. Collateral: auto loans.
Hybrid security between a loan and a bond can be traded like stocks but provide returns like bonds. These instruments offer investors a yield similar to government bonds but more favorable tax treatment.
An investment vehicle accepts cash from investors and uses that money to purchase assets further secured against those assets by solid collateral. Since the funds are received and then used to purchase more collateral, they will generate a return, and this return can be greater than what is paid out by the investors.
This hybrid security between a loan and a bond can be traded like stocks but provide returns like bonds. These instruments offer investors a yield similar to government bonds but more favorable tax treatment.
The main type of manager for CLOs is an Investment bank, which will break up the CLO into tranches with different levels of risk and return for investors. There are other investment banks with varying skill levels; typically, the more experienced managers have more skill because they understand risk management and have experience in debt collection or loan originators.
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