These are corporate loans from syndicates of banks that are taken out, for example, by private-equity firms to pay for takeovers. They also argue that CLOs are better regulated , and carry weightier buffers against default through a more conservative product design. None of this is untrue, but this do not mean risk has disappeared. Mortgages, for example, had low rate of defaults in the s and early s. But since CDOs enabled banks to sell on their mortgages to free up their balance sheets for more lending, they began lending to riskier customers in their search for more business.
This relaxation of lending standards into subprime mortgages - mortgages issued to borrowers with a poor credit rating - increased the eventual default rate of CDOs as people who could ill afford their mortgages stopped repaying them. The danger is that the same appetite for CLOs may similarly reduce standards in leveraged lending. When homeowners failed to repay their mortgages and banks repossessed and sold their houses, they could recover substantial amounts that could be passed through to CDO investors.
However, companies are rather different to houses — their assets are not just bricks and mortar, but also intangible things like brands and reputation, which may be worthless in a default situation. Loans—usually first-lien bank loans to businesses—that are ranked below investment grade are initially sold to a CLO manager who bundles generally to multiple loans together and manages the consolidations, actively buying and selling loans. To fund the purchase of new debt, the CLO manager sells stakes in the CLO to outside investors in a structure called tranches.
Each tranche is a piece of the CLO, and it dictates who will be paid out first when the underlying loan payments are made. It also dictates the risk associated with the investment since investors who are paid last have a higher risk of default from the underlying loans. Investors who are paid out first have lower overall risk, but they receive smaller interest payments, as a result. Investors who are in later tranches may be paid last, but the interest payments are higher to compensate for the risk.
There are two types of tranches: debt tranches and equity tranches. Debt tranches, which as also called mezzanine tranches, are treated just like bonds and have credit ratings and coupon payments. These debt tranches are always in the front of the line in terms of repayment , although within the debt tranches, there is also a pecking order. Equity tranches do not have credit ratings and are paid out after all debt tranches. Equity tranches are rarely paid a cash flow but do offer ownership in the CLO itself in the event of a sale.
A CLO is an actively managed instrument: managers can—and do—buy and sell individual bank loans in the underlying collateral pool in an effort to score gains and minimize losses.
In addition, most of a CLO's debt is backed by high-quality collateral, making liquidation less likely, and making it better equipped to withstand market volatility. CLOs offer higher-than-average returns because an investor is assuming more risk by buying low-rated debt. Some argue that a CLO isn't that risky. Research conducted by Guggenheim Investments, an asset management firm, found that from to , CLOs experienced significantly lower default rates than corporate bonds.
Only 0. Even so, they are sophisticated investments, and typically, only large institutional investors purchase tranches in a CLO. In other words, companies of scale, such as insurance companies, quickly purchase senior-level debt tranches to ensure low risk and steady cash flow. Mutual funds and ETFs normally purchase junior-level debt tranches with higher risk and higher interest payments. On the other hand, CDOs are mostly of individuals comprising of housing mortgaged loans, unsecured credit card debts, personal loans, etc.
Talking of who could trigger the next financial crisis, we can say both are unlikely to trigger crises now. Following the crisis, CDOs are facing more regulations now, and thus, are not as risky as they were at the time.
Coming to CLOs, they have a less complex structure and have fewer exposures to derivatives. Additionally, the bank balance sheets are more robust now than they were a decade back. Moreover, the banks usually invest in the CLO tranches that have the highest rating.
One more reason why CLOs are relatively less risky because of the financial analysts. By analyzing corporate loans, the analysts are able to come up with their verdict on the company. This way, any issue with the company taking a loan gets public well before it grows dangerous. CDOs, because of their role in the financial crisis, are now less popular than before.
Also, they are now subject to more regulations. CLOs, on the other hand, are popular because of their less complex structure. Moreover, they do not present a threat to the overall financial system since banks usually have exposure to the highest rating CLO tranches.
He is passionate about keeping and making things simple and easy. However, quite often, corporate exposures are held in the form of bonds. Hence, collateralized bond obligations CBOs would refer to securitization of a pool of corporate bonds. More likely than not, a securitization of corporate exposures would include both loans and bonds—hence, the term CDO was more appropriate.
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