Collateralized Loan Obligations: Complex Investments that Profit Off Debt
Collateralized Loan Obligations (CLOs) are investments comprised of securitized loans. Banks pool the loans and package them as investments, allowing investors to invest in debt from multiple loans. Investors may want to invest in debt as a way to diversify their portfolios. Usually, CLOs are comprised of senior secured loans. “Secured” loans have some type of collateral, which means they are more likely to be paid back even if the borrowing company goes out of business.
Collateralized Loan Obligation Tranches
CLOs are divided into tranches. Tranches are selections that have different credit ratings. If the borrower defaults on the loan, the investor suffers a loss. The riskier the tranche, the bigger the possible return. Riskier tranches also pay out to investors after lower-risk tranches. As in any security, investors should only take on this big-risk, big-reward proposition if they can financially withstand losing the entire investment.
Debt CLOs and Equity CLOs
There are two main types of collateralized loan obligations: equity CLOs and debt CLOs.
- CLOs may be sold as either debt tranches or equity tranches. Debt CLOs earn interest and make principal payments.
- Equity CLO investors receive any excess cash after the debt investors receive their share.
- Equity CLOs also offer the investor ownership of the CLO in case it sells.
CLOs and Stockbroker Fraud
CLOs can be particularly high risk since these debts are generally issued by non-investment grade businesses. You might hear that CLOs are not very high risk and offer lower default rates than corporate bonds. But that doesn’t necessarily mean they’re right for the average investor, and CLO investors are almost large, institutional investors.
If your stockbroker recommended a CLO, they may have failed to adhere to the suitability rule. FINRA Rule 2111 states that investors must have a reasonable basis for recommending an investment product. According to the rule, suitable investments factor in an investor’s financial situation, goals, and risk tolerance.
CLOs are floating rate loans, meaning the interest rate adjusts with the market. Your stockbroker may have highlighted this fact—a CLO may help to hedge against inflation. If interest rates are low, chances are that the rates will increase, and therefore so will the payments that the borrowers must pay. On the other hand, those increases could make the payments too high for the borrowers to afford, forcing them to default. Any stockbroker who recommends a CLO should explain how interest rates might affect the investment. Omission of material information is a violation of FINRA Rule 2020 and could form the basis for a FINRA arbitration claim.
Who Can Manage a Collateralized Loan Obligation?
Under the Dodd-Frank Act, CLO managers must be registered advisers with the SEC. You can check a manager’s registration on the SEC’s Investment Advisor Public Database.
The collateralized loan manager actively manages the CLO. They buy and sell loans to earn the best return possible for the investor. If a CLO is losing money, they will try to swap if out for a CLO that performs better.
Phases of a CLO:
- Warehousing: Managers purchase initial collateral.
- Ramp-Up: Managers purchase remaining collateral and perform tests to ensure the CLO can pay interest and principal payments.
- Reinvestment: Managers reinvest interest and adjust the selection of loans to improve the portfolio.
The loan CLO investors receive their payments first, followed by the equity CLO investors.
Under the Volcker Rule, CLO managers can be removed “for cause” under certain circumstances. These causes are not necessarily related to the performance of the CLO or the manager’s exercise of investment discretion:
- Bankruptcy or insolvency of the manager
- Breach of the CLO’s transaction agreements
- Criminal conduct
What Does Your Stockbroker Owe You?
Stockbrokers have an obligation under FINRA Rule 2111 to only recommend investments that suit your needs. If your broker recommended unsuitable investments that resulted in losses that took you by surprise, you may have a case for FINRA arbitration—the dispute resolution service that investors use instead of a civil suit. Most brokers require that you agree to settle disputes using FINRA arbitration as part of your contract with the firm.