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Investor Protection

‘Sliced and Diced’ CLOs Look Riskier

June 24, 2020

by Howard Haykin


Collateralized Loan Obligations, or CLOs, are financially-engineered securities that are created by pooling debt from hundreds of companies - often corporate loans with low credit ratings or leveraged buyouts made by private equity firms. By pooling and diversifying their holdings, CLOs manage to transform risky loans into highly rated, safe investments that pay better yields than, say, Treasurys. That is, until COVID-19 struck.


You see, the safety element behind CLOs is that different businesses are extremely unlikely to all hit problems simultaneously. But with the coronavirus and its broad impact across a wide swath of businesses and industries, those presumptions don't necessarily apply. Industries like travel and leisure, commercial real estate, brick-and-mortar retailing, dining, sports and recreation, entertainment and education have all suffered, and each must now must recover while facing a sceptical public and incorporating new methodologies and added costs.  



INVESTOR TAKE AWAYS.   Given that 'only' $700 billion or so of CLO debt has been created in recent years, the overall impact on investors and the fixed income markets is large but not overwhelming. And it's certainly not as significant as 12 years ago when, during the credit crisis of 2008, the U.S. economy suffered enormous losses as the massive subprime-mortgage market collapsed. And, as we saw, the economy eventually recovered.


Yet, the troubles with CLOs serve as a reminder that there are “NO FREE LUNCHES” - that higher-yielding investments come with higher risks. Investors should, therefore, invest according to their risk tolerance levels. Which means ... if you can’t stand the heat from risky investments, then it's best to avoid complicated financial products and stick with simple bank accounts, index funds and money market funds.



For further details on Collateralized Loan Obligations, click on these publications: