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Debunking four common myths about CLOs

Fixed Income Portfolio Manager Alyssa Irving sets the record straight regarding the risks and potential benefits of investing in collateralized loan obligations (CLOs).

Views expressed are those of the author and are subject to change. Other teams may hold different views and make different investment decisions. While any third-party data used is considered reliable, its accuracy is not guaranteed.

KEY POINTS

  • Collateralized loan obligations (CLOs) have typically not been portrayed in a favorable light by the financial press, leading to several common investor misconceptions about CLOs.
  • We continue to have high conviction in CLOs, but given the later stages of the current credit cycle, we are being careful and selective with regard to where we invest.
  • We see compelling value in the AAA, AA, and A tranches of CLO debt (but not the BB tranche), while equity tranches look attractive for higher-return-seeking investors.

CLOS ARE PERSISTENTLY IN THE FINANCIAL HEADLINES, and most of the over-the-top articles would have you believe they are the next crisis waiting to happen. While such fearmongering may make for a good news story, we do not believe it presents a fair or accurate assessment of the actual risks that CLO investments pose — or the benefits they may offer many investors. Here we aim to debunk four common CLO-related myths that have been perpetuated by the press.

Myth #1: All CLOs are levered investments.

Facts:

  • CLOs do not contain leverage or any type of borrowing. Rather, a CLO issues debt to finance the purchase of a portfolio of broadly syndicated bank loans that is actively managed by a bank loan manager. If US$500 million of debt is raised, for example, US$500 million of bank loans is purchased (less fees).
  • CLO equity is a levered investment (~11x) in the underlying broadly syndicated bank loan pool, as is the BB tranche (~8x levered). CLO mezzanine and equity investors buy the most junior tranches of the CLO, thereby structurally subordinating themselves and creating a levered investment in the underlying bank loan pool. There is no borrowing involved; there are no more dollars invested in bank loans than were raised by the issuance of debt to institutional investors…

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