{"id":5352,"date":"2022-08-25T05:13:00","date_gmt":"2022-08-25T05:13:00","guid":{"rendered":"https:\/\/thewealthcircle.com\/?p=5352"},"modified":"2022-08-25T07:44:37","modified_gmt":"2022-08-25T07:44:37","slug":"collateralized-loan-obligations","status":"publish","type":"post","link":"https:\/\/kiiky.com\/wealth\/collateralized-loan-obligations\/","title":{"rendered":"What Is Collateralized Loan Obligations? How it Works, Pros and Cons","gt_translate_keys":[{"key":"rendered","format":"text"}]},"content":{"rendered":"\n

A collateralized loan obligation (CLO)<\/strong> is a sophisticated financial instrument in which investors receive a small portion of the payments from hundreds of business loans.<\/p>\n\n\n\n

In this article, we’re going to keenly define collateralized loan obligations, how it works, and other relevant information.<\/p>\n\n\n\n

Before we define collateralized loan obligations, take a quick look at the table of contents below.<\/p>\n\n\n\n\n\n

What Is Collateralized Loan Obligations?<\/span><\/h2>\n\n\n\n

According to Wikipedia<\/a><\/strong>, Collateralized loan obligations are a form of securitization where payments from multiple middle-sized and large business loans are pooled together and passed on to different classes of owners in various tranches. A CLO is a type of collateralized debt obligation.<\/p>\n\n\n\n

Investopedia <\/a>further posits that collateralized loan obligations (CLO) are often approved by corporate loans with low credit ratings or loans taken out of private equity firms to conduct leveraged buyouts.<\/p>\n\n\n\n

With a CLO, the investor gets scheduled debt payments from the underlying loans, assuming most of the risk in the event that borrowers default. In exchange for taking on the default risk, the investor is offered greater diversity and the potential for higher than average returns.<\/p>\n\n\n\n

In few lines, you’ll find out how CLO works. <\/p>\n\n\n\n

SEE ALSO: Is it better to Save or Pay off debt?<\/a><\/p>\n\n\n\n

How Collateralized Loan Obligation Works<\/span><\/h2>\n\n\n\n

First-lien bank loans to businesses that are ranked below investment grade are initially sold to a CLO manager who gathers various loans together and maintains the consolidation, actively buying and selling loans<\/strong>. To finance the purchase of new debt, the CLO manager sells stakes in the CLO to outside investors in a structure called tranches. Each tranche is a piece of the CLO, and it dictates who gets paid first when the underlying loan payments are made.<\/p>\n\n\n\n

It also prescribes the risk associated with the investment, since investors who are paid last have a higher risk of default from the underlying loans. Investors who are paid out first have lower overall risk, but they receive smaller interest payments. Investors who are in later tranches may be paid last, but the interest payments are higher to compensate for the risk.<\/p>\n\n\n\n

There are four stages of the CLO life cycle, which occur over eight to 10 years:<\/p>\n\n\n\n

  1. Warehousing<\/li>
  2. Issuance<\/li>
  3. Expansion<\/li>
  4. Repayment<\/li><\/ol>\n\n\n\n

    Warehousing<\/span><\/h3>\n\n\n\n

    This is where the owners of the collateralized loan obligation create a structured investment vehicle. It’s like establishing a company in the business of buying loans. But, to purchase those loans, they first need to raise some capital.<\/p>\n\n\n\n

    To get started, the CLO takes out a short-term loan from a warehouse provider. This money is used to acquire an initial suite of loans to create a portfolio. This debt is paid off with money raised during the issuance of the CLO.<\/p>\n\n\n\n

    Issuance<\/span><\/h3>\n\n\n\n

    After warehousing, the CLO then looks to investors to finance the endeavor. This is done by selling what are effectively bonds in tranches, with a return on investment proportionate with the risk. Insurance companies, large banks, and pension funds often purchase these securities.<\/p>\n\n\n\n

    They offer senior-level debt that receives first call on revenues. That financial security would have the least risk and lowest coupon rate. Therefore, it would receive a rating of AAA or AA.<\/p>\n\n\n\n

    If an investor is looking for a better return and is willing to take a little more risk, they might purchase junior level debt. These securities are subordinate to the senior level debt, meaning they only get paid once the higher level debt is satisfied. These securities might get rated A or BBB.<\/p>\n\n\n\n

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