These loans are secured by collateral and have a long, well-documented history of protecting lenders when they default, with recoveries averaging 70-75%. The assets that are the "raw material" from which CLOs are constructed are senior, secured floating-rate term loans to non-investment grade corporations. But equity owners also absorb all the losses from borrowers who default and fail to pay, which is where things get interesting. Whether a bank or a CLO, the equity owners at the bottom of the balance sheet get all the excess spread between (1) the interest received on the loan assets, and (2) the interest, at a lower rate, paid out to depositors or creditors. The key to making money, for both banks and CLOs, is (1) to have as big a spread as possible between the interest rate you collect on your loan portfolio, and the rate you pay on your bank deposits or CLO borrowings, and (2) to leverage that borrowing as much as you prudently can, so you can collect the spread multiple times. Buying the equity in a CLO is like buying the stock of a bank, where the CLO/bank acquires a portfolio of loans that pay an interest rate (perhaps 5% or so), using funds that include (1) its own equity capital, and (2) money borrowed from investors (in the case of a CLO), or taken as deposits (in the case of a bank). For those who don't, we have this article.ĬLOs are virtual banks. Mythical and overly simplistic as that maxim may be, there's a germ of truth in it and anyone who truly "gets it" will understand immediately how Collateralized Loan Obligations (CLOs) work. Many years ago there was an adage about bankers that they lived and worked according to the "3-6-3 rule." They paid their customers 3% on their deposits, loaned the money out at 6%, and were on the golf course by 3:00 pm. If parts of this article seem familiar, it may be because it covers some of the same ground as Chapter 13 in my book, The Income Factory: An Investor's Guide to Consistent Lifetime Returns (McGraw-Hill, 2020). It won't make anybody an expert, but is intended to give readers a basic framework on which to build a greater understanding going forward. This article is intended to be an introduction to CLOs. Nobody expects to be able to predict actual future results, but most investors would like to be able to understand the factors that influence those results, both positively and negatively. The goal is to help investors understand what they are buying and how to anticipate or project potential results under various economic and financial market scenarios. Many of these funds have made efforts to get up the curve in explaining the CLO asset class in a transparent way to retail investors. Which bet do you think is easier to win? That's the difference between credit and equity.)įor the past 30 years or so, CLOs have been available to institutional investors, but only in recent years have become accessible to retail investors, through a number of closed-end funds, including Eagle Point Credit ( ECC), Oxford Lane Capital ( OXLC), XAI Octagon Floating Rate & Alternative Income Term Trust ( XFLT ), OFS Credit Company ( OCCI ), Eagle Point Income ( EIC ) (for CLO debt only, not equity), and Ares Dynamic Credit Allocation ( ARDC ) (which owns CLO debt and equity for about 30% of its portfolio). (Hint: Think of betting on a horse to merely finish the race as opposed to betting on a horse to win, place or show. Collateralized Loan Obligations ("CLOs") are an ideal way to earn an equity return by making more predictable "credit bets" rather than more potentially volatile "equity bets," a concept explained here in more detail. I published a version of this article earlier this month for my "Inside the Income Factory" members. Megaflopp/iStock via Getty Images Background: "Equity Returns" With Credit Investments
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