Mortgage backed securities, like CLOs, are a subcategory of collateralised debt obligations (CDOs). CDOs are debt securities that pool together debt instruments e.g. loans, bonds, mortgages etc. to offer investors an investment product that seeks to provide some diversification benefits versus purchasing a single debt instrument alone.

As well as offering loan diversification, when you invest in a CLO you can also decide how much risk exposure you want to take on the underlying loans. This is because CLOs are split into risk buckets, known as tranches, which create a waterfall structure within the CLO. The waterfall structure means that cash payments received on the underlying loans initially go to pay investors in the lowest risk tranche of the CLO. Once that tranche payment is covered, the remaining cash trickles over to pay investors in the second lowest risk tranche and, so on. This means that if a small number of underlying loans default, the highest risk tranches absorb these losses first whilst investors in the lowest risk tranche of the CLO may continue to receive their normal level of return.

CLOs offer investors a financial debt instrument that can help diversify away a single loan’s default risk (specific risk) and give investors the potential to better tailor their overall risk exposure to loans to more appropriately suit their individual level of risk tolerance. However it is important to understand that, as with any financial instrument, not all risk can be diversified away. Investors will still be exposed to economic wide risk (systematic risk) which is exacerbated during times of financial and economic stress – as we are now seeing under Covid-19.

Furthermore, the overall quality of a CLO ultimately depends upon the quality and stringency with which lending standards and loan covenants were applied at the point of issuance of the underlying loans. Anecdotally there have been murmurs that lending standards had slipped over the past few years and today that might mean CLO risks are underappreciated.

Poignantly the Financial Times recently wrote that the top tranche of a CLO has never defaulted. This statement fills me with dread. For it implies that the top tier tranche of CLOs have garnered a ‘safe’ reputation. I fear this reputation may have inadvertently shortened the depth of due diligence undertaken on the loans that make up CLOs. I also suspect that the longer a reputation builds; the greater the complacency becomes.

It is important to understand that, as with any financial instrument, not all risk can be diversified away.

Since the start of 2020, CLO yields have risen. I believe this represents the market attempting to re-assess what Coronavirus may mean for the credit worthiness of the underlying loans. Yet, if underlying lending standards have become too lax – investors may be unaware of their true risk exposures. All financial crises affect different parts of the economy to differing degrees. This financial crisis would seem to impact companies to a greater initial degree than consumers. So, whilst CLOs have weathered previous storms … this time may be different…

CLOs and CDOs are categorised as complex products and therefore JM Finn cannot transact in these securities on behalf of clients. However, certain collective investment schemes that clients may invest in will own these types of products, though these will also be categorised as complex.

Illustration by Sir Radar Drench

Managing your wealth

Managing your wealth

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