The film “The Big Short” stirred up bad memories of the financial crisis for many investors. While it was certainly entertaining to see pop star Selena Gomez liken synthetic collateralized debt obligations to a blackjack game with ever-increasing side bets, the losses many experienced from toxic three-letter securitized instruments were no laughing matter.
As the crisis wore on, investors worried that a similar-sounding security — collateralized loan obligations — could suffer the same fate as the subprime mortgage-backed investments dramatized on the big screen. Those fears abated as CLOs generally emerged intact, providing attractive returns for investors who focused on credit fundamentals and rode out the storm.
Recent commodity price swings and volatility in the broader credit markets have fueled fresh concerns about CLOs, which have recently traded at sharp discounts to similarly rated investments and could present attractive value opportunities for investors who take the time to understand this often misunderstood asset class.
Although tarred with the same brush during the financial crisis, CLOs are a fundamentally different form of structured investment from CDOs. Unlike the opaque underlying collateral associated with the subprime credit products of the crisis, a CLO is backed by a diverse pool of senior secured, broadly syndicated bank loans from issuers that would be familiar to most institutional investors. A typical CLO consists of 150 to 200 loans diversified across 15 to 25 industries with an average credit rating in the B1/B2 range.