Over the past few days I’ve gone down a rather deep rabbit hole within the topic of Collateralized Loan Obligations (CLOs). This came from pulling on the thread from Athene’s Retirement Services Day. It was outlined that CLOs are an under-appreciated asset class for myriad reasons, and is a source of outperformance for the insurer balance sheet. I understood the basics of the reasoning, but didn’t understand some of the foundational elements of CLOs. Furthermore CLOs sound similar to its bugaboo cousin, CDOs, the star of the ’08 financial crisis.
Over the past few months I’ve been periodically digging, but finally got serious about really understanding CLOs recently. If interested, see the below thread (below is the last post in the thread) for all of the resources I’ve pulled and posted for others to join in:
As I mentioned in my prior post, I’ve been pulled towards investing with fewer variables that have to be “predicted” or understood, a nod to how difficult it can be to get an edge as a retail investor in any part of the market. In many ways, CLOs offer a very structured investment vehicle with clear inputs and outputs.
The way I understand CLOs is as a simple bank with a secure long term funding base (versus deposits that can flee any given day), and a rules based approach to how the loans are managed versus management making human based decisions. It doesn’t need to grow like a business does, it doesn’t have to deal with overhead like a business, it doesn’t have to worry about competitors explicitly, and it can potentially benefit from market upheaval.
To be clear, there are always downsides to everything. CLOs struggled with getting primed during Covid when companies went into bankruptcy and the covenant light nature of the loans paired with the CLO’s lack of access to incremental capital put them at a disadvantage to distressed funds. But the interesting thing about CLOs is that while they have been around for ~25 years now, every negative event results in improved documentation that helps govern against such an event in the future.
But what does that mean for a retail investor? CLOs can be interesting because they tend to sell off in tandem as markets recoil. Why – as CLO owners aren’t necessarily forced sellers? Nobody can perfectly explain why prices move the way they do, but one reason is liquid funds that invest in bank loans (they key ingredient in a CLO’s asset base) see outflows during market dislocations, which push bank loan pricing down, and thus reduce the liquidation value of CLOs. This may offer a way to get discounted access to investment grade, non-investment grade, and equity layers, individually, of the CLO market. Access is now available via ETFs and interval funds for each broad CLO ratings layer – but buyer beware, the manager matters.
I recommend Flat Rock Global’s CLO primer to learn more, as it goes through all the basics, the acronyms, and mechanics of the CDO lifecycle in detail. And I recommend the podcast The Last Tranche to understand how CLO managers were reacting during and after Covid.
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[…] looked at Apollo’s middle market BDC (also here, here, and here) and how I’ve been looking at CLOs. Linking to these posts forced me to look at them again and virtually all of them made me feel a […]