CLO 101
Anyone generous enough to explain CLOs and their role in the overall credit market? Think many beginners could benefit from this. Like, I understand they'd want to lock in good margins on the TLBs they buy at the right risk level/rating, and the bigger the spread vs. AAA tranche, the more money they have left to distribute/return
But it's all a bit fuzzy to me. I have read some securitisation primers online but am not sure I'm getting the core/ what really matters
For example, they buy rated stuff, but their own stack is also rated? How come? Or did I get it wrong - AAA is they AAA stuff they buy and the return there barely covers what they need to pay for the part they borrowed, hence AAA tranche is the base to make it viable and all above is up for grabs?
Thanks in advance!
Collateralized Loan Obligations (CLOs) are a type of structured credit product that pools together leveraged loans (typically senior secured loans issued by companies with below-investment-grade credit ratings) and slices them into tranches with varying levels of risk and return. Here's a breakdown to clarify the key aspects and their role in the credit market:
Structure of a CLO:
How CLOs Work:
Why CLO Tranches Are Rated:
Role in the Credit Market:
Profitability and Margins:
Key Considerations:
In summary, CLOs play a vital role in the credit market by providing funding for leveraged loans, offering tailored risk/return profiles to investors, and enhancing market liquidity. They are complex instruments, but understanding the basics of their structure and cash flow mechanics is key to grasping their function. If you're looking for more detailed insights, the WSO forums and threads like "The CLO Sell Side Experience" (url: https://www.wallstreetoasis.com/forum/trading/the-clo-sell-side-experie…) are excellent resources.
Sources: The CLO Sell Side experience, CLO Asset Manager, The CLO Sell Side experience, Overview of Leveraged Finance, 1st Year Macro HF Analyst: My Macro Framework
Thank you bot, will read later
If you PM I can send you a good primer I got at a CLO internship. 120+ slides but very detailed (a little dated though from 2017).
Would be interested in primer if you could share
I would also be interested in the primer if you could share
Also interested in the primer!
Also interested in the primer if you don’t mind sharing it.
interested in the primer if you dont mind sharing thank you
Interested in this primer please!
Would also be interested in the primer if you would not mind sharing
Also interested if you could share
I would be interested if you could share
I'm interested in reading the primer as well if you don't mind sharing.
Also interested!
Would appreciate if you could share as well
Hey man, would love to take a look at the primer if you got a chance to send over. Thanks!
Would be interested in looking at the Primer, could you please share? Thanks.
could you please dm me the primer as well?
Would be interested in primer if you could share
Interested too, thanks!
Been quite a while since your comment but would be great to get the primer as well. Thanks in advance.
Im interested in the primer aswell
Appreciate if you could share this with me as well
Anyone got the primer? Interested to have it too please
Have an upcoming case study at a credit HF - would you be able to share the primer with me?
Would love to read the primer as well if still willing to share!
I would also be interested in the primer
I would also be interested in it
Super late to the party but could I also get a copy
super late to the function as well, but any shot you could send over the primer? Thanks
Flat Rock has a helpful white paper on CLO equity / BB notes which will help get you there. They even turned it into a book on Amazon, it's a quick read. You'll gain a thorough understanding of the entire structure in about two hours.
Read this Santander book here. It's probably one of the best materials available publicly. I like the Barclays Primer better, it's more in depth, but you'd need to find someone with access to Barclays research solutions.
But let me answer your questions a little bit. CLO AAA tranches are rated triple AAA because historically the recovery for first lien debt is somewhere around 70% and there's structural protections. You can kind of get why if you have the top rated tranche structured as say 60% of the capital structure, that gives you a lot of buffer before the AAA tranche fails (i.e. every loan has to default and lose more than the historical recovery.) The top-rated tranche possesses different mechanisms to safeguard their piece, like diverting interest and cash flows from junior tranches in the event of widespread credit defaults. Historically a AAA tranche has never failed, even with flawed structures in 2008 which is also part of the reason. AAA tranches are by far the most liquid and highly traded tranche. The more junior tranches tend to be fairly illiquid.
The underlying collateral is almost entirely single B loans, in the S+300-375bps range, probably issued at private equity owned portfolio companies. AAA tranche average spread is like S+110-150bps now IIRC. So you have a good excess that go into the 40% of the capital structure that isn't AAA.
Now let's talk about the shit that isn't in the primer. First off, the recovery rate for leveraged loans is way below 70%. Sometimes 25% or less. Part of this is the nature of the companies now versus the past - a good deal of defaults since 2021 are healthcare services companies which tend to be very asset lite and human capital intensive so not a lot of recovery if something goes wrong. The other is that loan investors have by and large traded safety for spread and so the documents governing most of the loans has gotten hilariously bad. I mean you look at a Silver Lake loan and you see so much bad shit that jumps off the page your eyeball pops out. Things like highwater marking of EBITDA, caps on voting rights, unlimited non-guarantor debt. Also the rise of LMEs or liability management exercise - these are restructuring transactions that benefit one group of creditors over another by giving this group enhanced recovery while the other gets zilch. CLO investors are not super-good at participating in these transactions because typically you need to have an affiliate whose mandate is investing in these deals and a relatively sharp credit manager to understand the underlying documents. This is also why there's an advantage in scale because the bigger guys tend to get invited to these group.
There's been rise of "alternative" CLOs like commercial real estate CLOs or private credit CLOs. These are also composed of loans like a normal CLO, but these CLOs are composed of more illiquid sector specific loans. For example, there's CRE CLOs focused on multifamily apartments originated by Arbor or MF1 and private credit CLOs issued by Golub or Ares. Now you get more bang for buck in terms of spread since the average private credit loan is somewhere in the range of S+400-S+600bps so you can add more spread, but you are giving away the liquidity of the underlying loan in case something bad happens. There's a lot of weird things in this space like how in private credit CLOs each loan has a shadow rating by Moody's/S&P that isn't public and is paid for by the CLO. The other is that both CRE CLOs and private credit CLOs tend to have weird concentrations. CRE CLOs have a fuck ton of ugly decaying 1970s Sunbelt apartment loans that are hilariously underwater. Private credit has a hard-on for loans to software companies that never make money.
Ask me any questions. I'm a little hungover and relying on my memory on a lot of this.
thank you for taking the time!
will read the primer and read your comment again
Also let me stand on my soapbox and ramble a little more. Historically the biggest whale in the CLO market was Norichukin Bank or Nochu Bank, which is a bank for Japanese farms. At one point this bank was a huge percentage of the market in like 2019 - I want to say like 30%. Anyways, they would buy huge slugs of the AAA tranche but the Japanese government grew concerned that like, this one bank was a huge percentage of the market. So Nochu gradually stopped investing in CLOs for a little bit and then decided the interest rates were going down, not up in 2021 and got gassed because of the rise in duration. So now Nochu is getting back into CLOs because the AAA tranche is super attractive to a bank because it's essentially tiny in terms of risk-weighted capital and zero duration. The largest CLO investors in the AAA tranche tend to be Japanese banks. Honestly, they should pay me to move to Japan and give me charge of capital allocation. I'd do a better job.
The other is that a lot of CLOs have ESG related metrics built in when these CLOs were originated in 2021, because large institutions like Nochu thought it was a good idea. These don't make any sense. I remember arguing why we gave Apollo an 8 in governance on a scale of 1-10 where 1 is the management team is the Italian mafia (technically there was a bond out there the Italian mafia controlled, TBH I'd take the mafia over Apollo) and 10 is Warren Buffett. Or like how a cruise line was a 6 on the environmental side because they were investing in greener tech, but it's still like a fucking cruise ship. Or another case where a medical services company that served rural communities owned by a notorious private equity firm where I thought to myself no way is this a good idea, like someone is 100% getting exploited out there. It'll be interesting to see how this will factor in with state laws in Florida and Texas that are anti-ESG. I think being the arbiter of morality doesn't really make any sense as a finance guy who didn't take any philosophy courses, but more CLO investors should factor in the fact that sponsors will not hesitate to move collateral and prime you.
This is such a great post and thanks for the link. It’s what makes this site great (at times). Thank you and +SB
"CRE CLOs have a fuck ton of ugly decaying 1970s Sunbelt apartment loans that are hilariously underwater." Yet the rating agencies seem oblivious to this, as they haven't downgraded any $abr Arbor Realty Trust CLOs.
Quasi tenetur sapiente sit aut. In facere est non et consequatur architecto. Consequatur placeat ad quas veniam quasi.
Ex architecto accusamus vero ullam enim. Vel voluptatem et aut aut voluptatum voluptates. Id hic iusto blanditiis est aut ipsam.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...
Modi aspernatur ipsum dolor. Et modi adipisci reiciendis eos cum.