Investment Grade CLOs: Quality and Income
CLO debt tranches receive interest payments and principal based on a priority of payments. Senior tranches carry investment grade ratings (AAA through BBB) and appeal to institutional investors such as pension funds, banks, and insurance companies. The most senior AAA tranche in a CLO has the lowest coupon rate, which increases as we go down the ratings spectrum.
The most senior AAA tranche, which has the most subordination, and thus a lower risk profile, also has the lowest coupon rate. Coupon rates increase at each tranche level as subordination decreases. However, these yields are typically higher than other comparably rated instruments.
Higher Yields with Mezzanine and Equity CLO Tranches
Mezzanine and equity CLO tranches receive higher rates of interest and distributions compared to investment grade CLO tranches to compensate for their lower subordination in the CLO structure.
CLO mezzanine tranches with a rating of BB and B are higher-yielding instruments that have historically been popular with hedge funds and opportunistic credit investors.
Attractive Risk-Adjusted Returns and High Cash-on-Cash Yields: CLO Equity
CLO equity offers the highest yields of all CLO tranches. They are often called “arbitrage” CLOs since they earn the difference between the total interest received from the underlying loan portfolio and interest payments to other CLO tranches (also known as a net interest margin).
CLO equity investors include CLO managers and opportunistic credit investors. The potential returns to CLO equity are high, but are subject to first loss in case of any defaults in underlying loans.
CLO Warehouses: The Precursor to a CLO
Prior to CLO creation, CLO managers build portfolios of senior bank loans through financing facilities known as CLO “warehouses” Investors can provide capital to the CLO warehouse so the facility can begin to accumulate loans with the goal of a CLO term out.
Warehouse investors lend money with the expectation of repayment when the CLO is issued. In doing so, warehouse investors access opportunities for enhanced yield on the term out CLO.