With markets navigating volatility and pressure in various sectors, some market participants have turned the conversation to the potential risks that Collateralized Loan Obligations or CLOs may pose.
So, what is a CLO? CLOs are structured finance securities backed by pools of loans made to highly-leveraged companies. Some news stories have led to the misperception that CLOs are the same as, or very similar to Collateralized Debt Obligations (CDOs) from Global Financial Crisis.
It is correct to say that both CLOs and CDOs assemble pools of financial assets and divide them into tranches (or slices) that offer varying levels of risks for different levels of return (yield). One or more tranches of a CDO or CLO may be rated by one or more credit rating agencies. Lower rated tranches usually pay higher yields because they are at a higher risk of default and are first in line to absorb losses in the event that the underlying pools of assets supporting the transaction suffer losses.
In brief, our ratings reflect our views of relative credit risk – the lower the rating, the higher the risk and vice versa.
However, this is where the similarities end.
Key CLO Facts:
- Unlike GFC-era CDO structures, CLOs are not backed by residential mortgage-backed securities (RMBS) or other synthetic structures tied to pools of RMBS.
- The vast majority of U.S. CLOs today are collateralized by loans (“leveraged loans”) made to corporate entities. A CLO manager usually builds CLOs by choosing corporate loans across a range of sectors, which aims to lower the overall portfolio risk.
- The U.S. CLO investor base is relatively diverse and includes different types of institutions focused on different parts of the CLO capital structure. U.S. and Japanese banks are the largest investors in U.S. CLO tranches by dollar amount, but their investments generally focus on the highest-rated CLO tranches.
- CLOs also represent a relatively small amount of the assets banks invest in, as regulatory filings show that less than 1% of total assets in the U.S. banking system are invested in CLO tranches (click here to read more).
- Federal Reserve Chairman recently offered his views on the CLO market during a testimony to the House Financial Services Committee, and that is available here.
- CLOs hold the underlying corporate loans that make up the asset pools supporting them and generally do not hold credit default swaps or other derivatives that could potentially amplify risks and losses.
Historical Performance of CLOs by Credit Rating:
- Historically, CLO tranche defaults have been limited: Of the more than 12,500 U.S. CLO tranches we’ve rated, only 40 have defaulted – and none of these were rated 'AAA'.
- Under our CLO rating criteria, a typical ‘AAA’-rated CLO tranche generally has par subordination of 35% (the percent of total capital that must be lost) to protect against losses.
- We’ve published various studies on how our CLO ratings might perform under various potential scenarios of market stress; you can view the most recent one here.
At S&P Global Ratings, our ratings on the companies that issue the loans and the recovery ratings on the loans themselves provide the foundation for most of our CLO ratings. We believe this interconnected approach provides all market participants a deeper level of analysis and greater transparency into our CLO ratings.
As part of our surveillance of CLO ratings, we continue to:
- Work closely with our corporate ratings analysts, who rate most CLOs’ underlying leveraged loans
- Monitor our rated CLOs for significant shifts in creditworthiness
- Actively engage with market participants to identify trends as they emerge
- Enhance transparency by publishing scenario analyses and regular research on the performance of CLO ratings and the underlying portfolio
Care to learn more about the CLOs of today and the CDOs from the previous decade? Start here to see how CLOs – and structured finance more broadly – have changed since the GFC.