Why CLO may be a good investment opportunity?

Development of CLO

Collateralized loan obligation (CLO) is a form of structured products. It pools hundreds of business loans and passes cash flows to tranches of different priorities in receiving cash flow. Normally, these business loans are from below investment grade companies, which normally need to provide higher yield in their bond issuance. CLO is great at attracting all types of investors from risk averse to risk taking, to invest in corporate debts which were considered risky and not suitable for risk averse investors.

The first CLO was issued in 1987, and it provided incentives for depository banks to securitize these loans and remove these loans from their books by selling them to outside investors. The 2007-08 financial crisis is a big hit on the CLO market, although the key reason for the crisis was from subprime mortgage instead of corporate loans. Investors doubted the safety of CLOs since they have a similar structure with problematic subprime Collateralized debt obligation (CDO) and CDO². However, CLO quickly gained favor from investors, and had been the first type of secured products that recovered to the pre-crisis trading volume. 

Safety

One advantage of CLO is that the AA and AAA rated CLO tranches NEVER experienced any defaulted events. This is magic since the collateral pool of CLO is formed of below investment grade corporate bonds. The waterfall structure of cash flows from senior to junior/equity tranches makes this happen. The zero default rate of AA and above tranches is at the expense of junior and equity tranches, which absorb loss before senior tranches when default happens. As a return, junior and equity tranches get compensated with higher expected yield and volatility.

Default rates for different rating bonds
	AAA	AA	A	BBB	BB	B
U.S. CLO 1994-2013	0.0%	0.0%	0.5%	0.3%	1.7%	2.6%
U.S. Corporate 5 YR	0.4%	0.5%	0.8%	2.4%	9.2%	21.4%
Source: Standard & Pool

From December 24, 2016, CLO managers are required to hold at least 5% of par value of each tranche. This is a great incentive for CLO managers to achieve due diligence in bond selection, since they may suffer loss with CLO investors when default happens.

Higher yield and embedded option

CLO AA and AAA rated tranches provide investors a higher return than ordinary corporate AA and AAA rated bonds. AAA rated tranches normally offer an additional 125+ basis points in additional to the three month Libor rate, while AA rated tranches normally provide 200+ basis points on top of the Libor rate. This compensation structure is good at eliminating the interest rate risk when the rate is currently keep increasing.

For major equity tranche investors, they absorb the first loss, but they enjoy higher expected returns and embedded options. Equity tranche is close to the stock investment, which claim interests after all debts paid off. In CLO investment, major equity tranche investors also have the right to let CLO managers pay off some or all debts ahead of maturity date. This is beneficial to equity tranche investors after they see credit deterioration risks in the collateral pool, and this option grants investors a right to get their principles back ahead of loss. There is another refinancing option given to major equity investors, which they can choose to let CLO managers refinance AAA, AA and/or other tranches. Refinancing lowers yields to senior tranches, so it will give higher expected yields to equity tranche investors.