A CLO Structure in 1 Chart

I’ve written just a bit about CLOs (collateralized Loan Obiligations) lately and was just doing some reading of a SEC filing by OFS Credit (OCCI)–another company with a business based on CLOs.

OFS Credit, Eagle Point, Oxford Lane and Priority Income Fund all have term preferreds outstanding–and from that fact stems our interest in the companys.

CLOs are kind of hard to explain–they are kind of black box investments. I ran across a chart that does a decent job of showing the structure of a CLO. Likely most everyone knows that a CLO is a package of junk rated debt that is repackaged and resold. The CLO starts off as junk and with some hocus pocus part of the package is turned into investment grade.

In this chart you can see the priority of payments to holders of the various tranches. Those at the top of the stack receive modest interest rate payments–but they have the least risk. Those at the bottom, what is called the equity class get the highest interest payments–but they are by far and away the class with out sized risk.

So the point is–know what you own. While I haven’t gotten into all the detail yet I can tell you most of the publicly traded holders of CLOs hold a large portion of the equity class–the riskiest class.

I know some readers will get tired of my writing about a particular subject–that’s ok. Part of my mission is to help educate newer folks to some of the risks out there. We have over 1,500 new visitors every day–they are googling for information–so if we can help even 5 people understand what they own we are successful.

21 thoughts on “A CLO Structure in 1 Chart”

  1. Thankyou Tim , I tip toe around these issues as to not get over exposed but the yield is a nice bump up. I’m pushing 70 and the risk to reward is kind of changes as the years go on. I still shy away from the K1 issues for lack of knowledge and the tax thing. Investing since 1968

    1. I know what you mean Mudshark–what I would have done 10 years ago is different from today–the risk/reward to seems to be tipping to risk.

  2. Not exactly black box or hocus pocus to anyone with knowledge of leverage finance. Total rates of return on BBB and BB CLO tranches have outperformed most all public fixed income investment and equities over the past 5 years

    1. Joseph–to the regular investor they are pretty much black box. BBB and BB are not the tranches Eagle Point, Oxford Lane or the others primarily invest in–they are mostly equity tranche. Thanks for your comment.

  3. Most of the senior tranches are held by insurance companies because they are always attracted to the income nature of the asset class. The spread between AAA/AA CLO and Corporate AAA is another attraction as insurers can risk budget against the CLO and get more yield given what else is available in the fixed income market. The 4Q 2018 dislocation made other opportunities in the fixed income market more attractive versus CLO so there has been some rotation out of the CLO category.

    Its all about the collateral and transparency. The managers like the big fees and will feel sorry if things go bad.

    YMMV

    1. Tim, Just want to thank you (once again) and everybody in this community. I still think you should run for POTUS, but I know you won’t do it … You would be the tallest President since Honest Abe … I would nominate Grid as the VP candidate. Several contributors, Like Nomad, to fill those cabinet chairs.

      1. Bigbear–oh no–I would be the tallest, but I don’t even want to be on the school board.

    2. Yes it’s all about collateral. Do you have a sense for how much collateral protection/coverage the middle and upper tranches have?

      1. The guys from PGIM will be in a couple weeks and I will get some specific numbers. From my discussions with them, they love CLOs but they are only buying the highest tranches due to higher yield opportunities. Prudential’s philosophy is to hold the longest dated treasury portfolio and then trade around it when opportunities present themselves so their weighting in various other fixed income classes changes over time as net premiums come in.

        1. Thanks, Marc. Appreciate any insight.

          To what extent do you think owning baby bonds/preferreds of a fund investing in equity CLOs is kind of like owning CLOs at a high tranche? It’s kind of the same concept in which the layer below you (common shareholders) has to be exhausted before bond/preferreds take a hit. That said, it’s kind of different as with CLOs, there’s no requirement that the CLO liquidate and payout to higher tranches if collateral coverage tests are failed. Or is there?

  4. Thank you, Tim. I read your articles everyday and it’s helpful for me. Cause your selfless sharing and let me get a lot of knowledge. I’m live in Taiwan of Asia. Thanks again.

  5. Wow, at 1500 new visitors daily, you have obviously built a tremendous site.
    Thanks again for the info and gratz on the well deserved traction.

  6. The recently created Eagle Point Income (EIC) invests slightly higher up the CLO ladder:

    “We seek to achieve our investment objectives by investing primarily in junior debt tranches of CLOs. In addition, we may invest up to 20% of our total assets (at the time of investment) in CLO equity securities and related securities (primarily via minority ownership positions).”

  7. Tim- Great simple explanation . I got out of all BDC bonds and CEFs with CLO exposure. I’m trying to “KISS” and if I don’t understand it I’m passing. Everything is great until it isn’t. 99% of the retail folks buying these “safe” baby bonds etc because of the leverage rules just don’t realize when it blows up the leverage rules will work against them while the big boys (Oaktree, etc) will pick up the pieces and make a fortune. Thanks for the great work

    1. I agree with not investing in what don’t understand but the leverage rules do provide a very significant layer of protection. As the Wolf Street blog likes to say “nothing goes to heck in a straight line.” If there’s a true rapid blowup (as opposed to say a decade of stagnation like the 1970s) then there will be a bailout and an orderly unwinding of positions. In that case, the collateral protection provided by the leverage rules will save bond/preferred holders.

  8. Hello Tim
    Please don’t ever with-hold information or personal perspectives because “some readers” may get tired of it. Repetition is good! I have learned a lot from you and others here. I read that CLO article when researching SAR and other issues holding CLOs. Again, I really appreciate all that you do for us.

    1. Jeff-thanks. I need to try to get the newer folks (and us old ones) so that at least there are not giant surprises.

      I have owned–and right now own some of the term preferreds, but now I know how fast to run if the economy gets soft.

  9. “…if we can help even 5 people”… Thanks for this, Tim, I had no idea what the actual structure was, and the degree of danger. I suspect I’m not the only one needing a lot of education (mostly in what to avoid).

    1. MonkeywithDarts–glad maybe it is of some help. These items become critical if we move toward a recession–which doesn’t seem to be the case now–but it will come–someday.

      1. Tim. Thanks. I‘ve been investing since 2002 and thought I knew my way around but I’ve learned more in my past year here from you and the rest of the gang than I ever knew. Just to say if your mission is to educate, or to provide a forum for sharing information, then mission accomplished from my point of view. I’m still in the back of the class but at least I’m in the classroom. Thank You!

        1. I hear you Timdman–I learn more and more from all the folks. I figure if I can get to 100 I’ll be pretty smart.

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