CLOs: Fact vs. Fiction
Despite generating attractive returns with low default rates for more than a quarter century, CLOs are still a commonly misunderstood asset class.
Collateralized loan obligations (CLOs) have existed since the 1990s, but misconceptions surrounding the asset class persist. We present the following to help better understand this intriguing market segment and to separate fact from fiction.
Fiction:
CLOs are the same as CDOs and caused the financial crisis.
Fact:
Collateralized debt obligations (CDOs) is the broad term that describes a type of structured finance security that can be backed by a portfolio of various forms of debt including corporate loans and bonds. However, most people are aware of the CDOs that are backed by subprime residential mortgage-backed securities (RMBS). In the build-up to the Global Financial Crisis, subprime residential mortgages often had little or no documentation and were poorly underwritten. When housing prices crashed during 2007–2009, these highly correlated subprime mortgages experienced massive losses, which resulted in substantial defaults in RMBS CDO portfolios. Those defaults are what bled into the broader macro environment. But RMBS CDOs are not CLOs.
CLOs are a specific type of CDO that are primarily backed by highly diverse pools of senior secured loans. These loans have historically strong recovery rates averaging over 70% for the years spanning 1987–2022, and are typically made to large well-known corporate borrowers such as United Airlines, Virgin Media and Burger King, who provide extensive annual reporting.1 In an issuing company’s capital structure, these loans are usually senior to other outstanding debt, including high yield bonds. These loans are also secured by some or all of a borrower’s assets, which offers additional credit risk protection.
1. Source: Moody’s. As of March 13, 2023.
