A collateralized loan obligation (CLO) is a single security backed by a pool of debt. Often these are corporate loans that have a low credit rating or leveraged buyouts made by a private equity firm to take a controlling interest in an existing company. A collateralized loan obligation is similar to a collateralized mortgage obligation (CMO), except that the underlying debt is of a different type and character—a company loan instead of a mortgage.
With a CLO, the investor receives scheduled debt payments from the underlying loans, assuming most of the risk in the event that borrowers default. In exchange for taking on the default risk, the investor is offered greater diversity and the potential for higher-than-average returns. A default is when a borrower fails to make payments on a loan or mortgage for an extended period of time.
How a Collateralized Loan Obligation (CLO) Works
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.
KEY TAKEAWAYS
A collateralized loan obligation (CLO) is a single security backed by a pool of debt.
CLOs are often corporate loans with low credit ratings or leveraged buyouts made by private equity firms to take a controlling interest in a company.
With a CLO, the investor receives scheduled debt payments from the underlying loans, assuming most of the risk if borrowers default.
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.
CLOs offer higher-than-average returns because an investor is assuming more risk by buying low-rated debt.
Special Considerations for a CLO
Some argue that a CLO isn't that risky. A study by Guggenheim Investments, an asset management firm, found that from 1994 to 2013, CLOs experienced significantly lower default rates than corporate bonds. Even so, they are sophisticated investments, and typically, only large institutional investors purchase tranches in a CLO. In other words, companies of scale, such as insurance companies, quickly purchase senior level debt tranches to ensure low risk and steady cash flow. Mutual funds and ETFs normally purchase junior-level debt tranches with higher risk and higher interest payments. If an individual investor invests in a mutual fund with junior debt tranches, that investor takes on the proportional risk of default.
Trump’s New Trade War Tool Might Just Be Antique China Debt
Collectors of pre-Communist debt are lobbying the White House to force Beijing to make good.
By
Tracy Alloway
President Donald Trump’s next move in an increasingly fraught trade
war with China could be one for the history books, literally. The Trump
administration has been studying the unlikely prospect of reviving
century-old claims on Chinese bonds sold before the founding of the
communist People’s Republic.
The defaulted China bonds can be found in the attics and basements of thousands of Americans, or on EBay, where the certificates sell as collectibles
for as little as a few hundred dollars each. The PRC, which succeeded
the Republic of China after it replaced the imperial dynasty, has never
recognized the debt, though that hasn’t stopped decades of attempts to
collect payment on it.
Now, with Trump ratcheting up the trade rhetoric
with China, holders of the antiquarian bonds are hoping he’ll press
their case, even as other parts of the U.S. government are accusing
people of fraudulently selling the same paper.
Perhaps the only thing more peculiar than the story of the
Chinese debt and the bid to seek payment on it, is the cast of
characters drawn into its orbit. President Trump, U.S. Treasury
Secretary Steven Mnuchin, and U.S. Commerce Secretary Wilbur Ross have
met with bondholders and their representatives. Kirbyjon Caldwell,
pastor of a Texas megachurch and spiritual adviser to George W. Bush,
has been charged by the U.S securities regulator for selling the debt to
elderly retirees. (Caldwell has pleaded innocent and maintains that the
bonds are legitimate.)
“With
President Trump, it’s a whole new ballgame,” says Jonna Bianco, a
Tennessee cattle rancher who leads a group representing
pre-revolutionary China bondholders and who has met with the president.
“He’s an ‘America First' person. God bless him.”
Hundreds,
if not thousands, of these 5% Hukuang Railways Sinking Fund Gold Loan
of 1911 bonds—issued in 1911 by a consortium of banks in London, Berlin,
Paris, and New York—appear to have survived.
The
Hukuang Railway bond is a thing of beauty. Printed with an ornate
border and carrying a large chop, the debt was sold in 1911 to help fund
construction of a rail line stretching from Hankou to Szechuan.
The U.S. once referred to the money that flowed into China at
the turn of the 20th century as “dollar diplomacy”—a way of building
relations with the country (and its massive untapped market) by helping
it industrialize. The Chinese have another term for it: For them it fits
squarely into China’s “Hundred Years of Humiliation,” when the Middle
Kingdom was forced to agree to unfair foreign control.
Soon after
the imperial dynasty was overthrown in 1911, the Republic of China
began tapping the international capital markets for funding too. That
included selling a series of gold-backed notes to fund the nascent
country. It’s these bonds that Bianco, who co-founded the American
Bondholders Foundation in 2001 to represent holders of pre-communist
debt, is hoping could be a useful political leverage in Trump’s fight
with China.
“The People’s Republic of China dismisses its defaulted
sovereign obligations as pre-1949 Republic of China debt, but doing so
contradicts the PRC’s claim that it is sole successor to the ROC’s
sovereign rights,” Bianco said in an emailed statement in response to
this story.
Bianco says she’s spent years researching the issue
and recruiting high-profile proponents to the ABF team, including Bill
Bennett, who was U.S. Secretary of Education under Ronald Reagan; Brian
Kennedy, senior fellow at the Claremont Institute; and Michael Socarras,
Bush’s nominee for Air Force general counsel.
She argues that
China is in selective default, having paid out on bonds held by British
investors in 1987 as part of the Hong Kong handover deal negotiated by
former Prime Minister and ‘Irony Lady’ Margaret Thatcher. If China
doesn’t pay out, she says, it should be blocked from selling new debt in
international markets. By Bianco’s reckoning, China now owes more than
$1 trillion on the defaulted debt, once adjusted for inflation,
interest, and other damages—a sum roughly equivalent to China’s holdings
of U.S. Treasuries.
“What’s wrong with paying China with their own paper?” says Bianco.
From
left: President Trump, Jonna Bianco, and Brian Kennedy on Aug. 12,
2018, at the Trump National Golf Club in Bedminster, N.J.
Source: Jonna Bianco
She
met with Trump at his sprawling golf course in Bedminister, N.J., last
August, in an encounter she describes as “wonderful.” Since then she’s
met with Mnuchin, though she won’t reveal what was discussed. ABF reps,
including Bennett, Kennedy, and Socarras, met with Commerce Secretary
Ross in April, Bianco says.
People familiar with the Treasury
Department say the China bonds have been studied, but ABF’s
suggestions—including the possibility of selling the defaulted debt to
the U.S. government to then exchange with China—aren’t legally viable.
Spokespeople for Treasury and Commerce declined to comment. People
familiar with the views of Chinese officials say they’re aware of the
meetings, but they don’t think the claims can be revived.
At issue is a statute of limitations that has long run its
course and the fuzzy legal obligations of governments that inherit their
predecessor’s debts following civil upheavals. In one of the most
famous cases, the Soviet Union repudiated bonds sold under the Tsar,
inflicting losses on thousands of investors who had snapped up the
paper. Still, most agree that as a legal principle, political regimes
inherit their predecessors’ debt; most governments choose to honor old
bonds, in part because they don’t want to alienate investors who might
buy new ones.
“I think everyone who works for Trump at the
Treasury Department thinks this is loony,” says Mitu Gulati, law
professor at Duke University and a sovereign-debt restructuring expert.
“But I can’t help but be tickled pink, because at a legal level these
are perfectly valid debts. However, you’ve got to get a really clever
lawyer to activate them.”
Clever lawyers have tried before. The closest anyone got to
wringing payment out of China was a class action suit brought by holders
of Hukuang railway bonds in 1979 that managed to bring the PRC to court
to defend itself for the first time. Gene Theroux, formerly senior
counsel at Baker & McKenzie LLP, helped represent the Chinese
government in court.
Theroux, now retired, remembers the landmark
case well. “The requests of us as lawyers were occasionally unusual,” he
says, including China nixing any citation of previous cases with
“Republic of China” in the title, given its refusal to recognize the
regime under its “One China” policy. (Eventually, Baker & McKenzie
resolved the problem by citing old cases as “Republic of China
[so-called].”)
The suit was thrown out on the basis that the 1976
Foreign Sovereign Immunities Act, which allows U.S. courts to hear
cases against foreign governments for commercial claims, could not be
retroactively applied to bonds issued at the turn of the century.
Since then, a 2004 Supreme Court decision ruled that the FSIA could apply retroactively in a case immortalized in the movie Woman in Gold.
The ruling paved the way for Maria Altmann to reclaim paintings by the
famous Austrian artist Gustav Klimt decades after they’d been seized by
the Nazis.
That
still leaves the problem of reactivating modern legal claims on debt
that is now decades old. Gulati argues that this could perhaps be
done—for instance, by arguing that China making payments on modern bonds
violates pari passi (equal payment) clauses embedded in the
historic debt. Such clauses were successfully used by hedge funds
seeking payment from Argentina a few years ago. It’s a legal long shot,
but one that Gulati has assigned to his law students as a theoretical
exercise.
The U.S. Securities and Exchange Commission is studying
the debt, too. In a 2018 complaint against Pastor Caldwell and a
self-described financial planner named Gregory Alan Smith, the SEC accused the pair
of raising at least $3.4 million by persuading 29 investors to buy the
pre-revolutionary bonds. Some of the buyers, mostly elderly retirees,
liquidated their annuities to invest, the SEC said.
Messages left for Caldwell’s lawyer, Dan Cogdell, weren’t
returned. In a press conference in March, Cogdell said the charges
against his client were “false.” Caldwell, who was educated at Wharton
before working as a bond salesman at First Boston and going on to
officiate at Jenna Bush’s wedding, said the bonds are “legitimate” and
has returned money to investors at their request. Smith entered a plea
agreement to the charges last month.
“Defendants falsely
represented to these investors that the bonds were safe, risk-free,
worth tens, if not hundreds, of millions of dollars, and could be sold
to third parties,” the SEC said in its complaint. “In reality, the bonds
were mere collectible memorabilia with no investment value.”
—With Saleha Mosin, Jennifer Jacobs, and Steven Yang.
(Updates
with a U.K. bondholders agreement from 1987 in 11th paragraph .
Clarifies that ABF represents ROC bondholders in eighth paragraph,
includes response from ABF in ninth paragraph.)
