Unlocking the power of CLOs

As the financial landscape continues to evolve, investors are constantly seeking new opportunities to help diversify their portfolios and generate attractive returns. One investment that has gained significant attention in recent years is a collateralized loan obligation (CLO). CLOs may offer a unique and compelling investment proposition, providing exposure to the dynamic, and often resilient, leveraged loan market. Here are their key features, potential benefits, and what can make them a potentially compelling investment option.

Introduction to leveraged loans and CLOs

Leveraged loans are loans secured by a first or second lien on the assets of an issuer, rated BB+/Ba1 or lower, and are typically floating rate. These loans are often used to fund mergers and acquisitions (M&A) and leveraged buyouts by private equity sponsors. Unlike high yield bonds, leveraged loans aren’t considered securities and aren’t SEC registered. Initially structured by a bank or group of banks, these loans are divided among a group of lenders in the primary market and subsequently traded in the secondary market. Leveraged loans comprise the majority of CLO collateral.

A CLO is securitized by a pool of assets, including senior secured leveraged loans and bonds. It collects interest and principal distributions from the pool of assets — typically 200-400 unique borrowers — and governs the distribution of these collections based on a waterfall, or residual cash flow, clearly outlined within the CLO agreement.

CLO structure and management

Before issuance, the CLO is capitalized via the sale of portions of the debt (tranches) and equity. Once issued, a CLO portfolio is actively managed by a CLO manager who selects the initial pool of assets and may trade in and out of the assets over a typical four-to-five-year investment period. After two years, CLO debt tranches are typically callable, meaning that the issuer has the right to repay the debt before its scheduled maturity date. CLO managers receive a fee in exchange for their active management of the portfolio.

Coupon and principal payments collected on the underlying assets (loans) are used to make coupon and principal payments on the CLO’s liabilities (CLO notes). Payments first flow to the highest-rated debt tranche of the CLO structure and continue to the lowest rated debt tranche. Thereafter, the residual cash flows are distributed to the equity. This is referred to as the “cash flow waterfall.” CLOs are structured to capture the spread, or arbitrage, between the interest income received from the underlying loans and the interest paid out to the CLO note holders.

Potential benefits and considerations

CLOs offer several potential benefits to investors. First, they provide exposure to the leveraged loan market, which has historically shown resilience and attractive risk-adjusted returns. Second, the active management of CLO portfolios allows for dynamic adjustments to changing market conditions, potentially enhancing returns. Third, the structured nature of CLOs, with their tiered tranches, allows investors to choose the level of risk and return that aligns with their investment objectives.

It’s important for investors to understand the complexities and risks associated with CLOs. Their performance can be influenced by various factors, including the credit quality of the underlying loans, market liquidity, and economic conditions. That’s why CLOs are typically suited for professional and qualified clients and sophisticated investors who have the expertise to evaluate these factors.

Conclusion

CLOs offer a distinctive investment opportunity by providing access to the leveraged loan market. With active management and structured cash flow distribution, they can be an attractive option for sophisticated investors looking to diversify their portfolios and achieve appealing returns. As with any investment, it’s crucial for financial professionals and investors to understand the associated risks before investing in CLOs.

Invesco AAA CLO Floating Rate Note ETF

Investors seeking income, investment grade credit ratings, and securities with floating interest rates, may want to consider Invesco AAA CLO Floating Rate Note ETF (ICLO) Floating rate note securities issued by CLOs provide periodic coupon payments to investors, and ICLO primarily invests in AAA-rated securities, which are less sensitive to interest rate changes than fixed-rate securities.