Collateralized Loan Obligation, what are they? Features and risks
Collateralized Loan Obligation are instruments belonging to the asset backed securities category of which they represent a specific type. In short, CLOs are debt instruments that have been issued on a portfolio with various assets, different from one another, consisting of bonds, various types of securities and debt instruments.
These financial products come from securitization processes and are characterized by the presence in the loan portfolio of credit institutions and other companies. CLOs are usually issued as a result of transactions of assignment of receivables from one company (called Sponsor ) to another that has been specifically set up for the purchase of these credits (called SPV, or Special Purpose Vehicle). The company created in this specific transaction finances the purchase of the portfolio from the other company by issuing so-called CLOs on the market.
Usually the SVP company issues several CLO packages to be sold on the market, each of them marked by a particular degree of risk and by the application of a priority scale that privileges some reimbursements first compared to others. These packages, also referred to as ” tranches “, are divided into three types based on the priority of repayment stability by the acquiring company: the “subordinated tranche” is the last in the priority scale, the “junior tranche” has a slightly higher priority while the one that has the highest priority and that is repaid first is the so-called “senior tranche”, which provides for the full repayment of both capital and interest. Collateralized Loan Obligations are usually characterized by a very high rating and this is mainly due to the high diversification of the portfolio that acts as their underlying asset. This diversification, as in other similar financial transactions, leads to a considerable reduction in risk.
In the purely technical field, it can be assumed that the Collateralized Loan Obligations are very similar to the embryonic phase of another type of bond, ie the CMOs (Collateralized Mortgage Obligations) precisely for the process of distinct flows that differ in a different way and each a certain priority. They are therefore bonds guaranteed by a collateral subject in the form of several medium-high tranches of loans deriving from loans.
The risk of this financial instrument is rather high especially for the ” subordinated ” tranches, which are the first to be hit in the event of the insolvency of the underlying debtor. A curiosity: retail investors receive from institutional investors a part of the various types of bond tranches, with the former often not even aware of them.