For the last several years, collateralized loan obligations (“CLOs”) have been a darling of Wall Street.  CLOs are very similar to what turned out to be a toxic product, collateralized mortgage obligations (“CMOs”), which contributed to a banking freeze and the Great Recession a decade ago.

CLOs are similar to CMOs in that loans are made to risky borrowers in a time of easing regulations.  With CMOs, banks pooled many home mortgages together selling them to investors; however, now, instead of having high-risk homeowners, CLOs have replaced homeowners with high-risk companies.

CLOs consist of loans up to 300 already indebted corporate borrowers.  Companies with junk-level credit ratings are at an all-time high.  These loans are called leveraged loans. 

Moody’s and Standard & Poor’s are two of the largest bond rating companies.  The following chart provides an overview of different rating symbols.

One reason why these companies have junk-level credit ratings is that they are already carrying previous debt.  Despite having junk-level credit ratings with a high default risk, investors have not placed requirements of protection on the loans, called covenants, as they did in prior times.  For example, similar securities had covenants to prevent debtor companies from paying owners first, before investors.  Other covenants limited additional borrowing.  As a result of the lack of covenants, the majority of new loans are now called covenant-lite loans. 

A lesson learned from the Financial Crisis was that financial firms were less prudent when lending other people’s money.  One cannot help to associate these covenant-lite loans with “liar loans” of the previous decade where the banking industry removed safeguards to ensure property owners were in a position to repay their mortgages.

To remedy this problem, the Dodd-Frank financial regulation law required loan packagers to retain some of the risk of the investments they created.  In essence, to  have “skin in the game.”

However, in 2018, a U.S. Court of Appeal for the District of Columbia Circuit ruled CLOs no longer be forced to comply with the “skin in the game” requirements,  removing any risk retention safeguarding investors.

CLOs are extremely complicated, which raise questions whether a stockbroker, not only explains all material risks to an investor but does the investor have the financial acumen to understand and accept those risks.

According to Investopedia, a CLO works in the following manner:

Loans—usually first-lien bank loans to businesses—that are ranked below investment grade are initially sold to a CLO manager who bundles multiple (generally 100 to 225) loans together and manages the consolidations, actively buying and selling loans. To fund 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 will be paid out first when the underlying loan payments are made. It also dictates 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, as a result. Investors who are in later tranches may be paid last, but the interest payments are higher to compensate for the risk.

There are two types of tranches: debt tranches and equity tranches. Debt tranches are treated just like bonds and have credit ratings and coupon payments. These debt tranches are always in the front of the line in terms of repayment, although within the debt tranches, there is also a pecking order. Equity tranches do not have credit ratings and are paid out after all debt tranches. Equity tranches are rarely paid a cash flow but do offer ownership in the CLO itself in the event of a sale.

A CLO is an actively managed instrument: managers can—and do—buy and sell individual bank loans in the underlying collateral pool in an effort to score gains and minimize losses. In addition, most of a CLO's debt is backed by high-quality collateral, making liquidation less likely, and making it better equipped to withstand market volatility.

All is peachy until it is not.  As long as companies are paying back borrowed debt, investors typically adhere to their stockbrokers’ recommendations.  However, this last month has brought the country into an official recession.  Each day, the market spirals further and further out of control, relinquishing gains from the “boom” decade.  Due to the coronavirus, businesses have shut down, manufacturing has ceased, and workers let go.

How are these companies who had junk bond credit ratings during the boom years expected to meet their financial obligations?

As an investor, who would actually purchase CLOs if the risks were properly explained?  Who would recommend this investment if one understood the product?