INS Flipbooks

© 2023 SEI 2 the highest returns in the CLO structure. Conversely the equity tranche will also take losses first if the loans default on their payments to the CLO. • Priority of payments: Often referred to as the "payment waterfall", this refers to the sequential order in which cash flows derived from the underlying loans are allocated to the CLO fund investors. Put simply, investors in the highest-rated tranche receive interest and principal payments first while investors in the lowest-rated tranche – typically the equity tranche - receive payments only after all investors in higher-rated tranche are paid back in full. Note that investors may choose which debt tranches in which to invest. Economically, a CLO's equity tranche, while potentially the highest returning, is also the riskiest portion of the CLO. If some of the loans stop making payments (default) those payments will not reach the equity tranche and the equity tranche's return will be lower. The priority of cash flows and sequence of losses is diagramed in Exhibit 1 below. Exhibit 1: Understanding CLO structures Source: SEI. For illustrative purposes only. Why do people invest in CLOs? CLOs allow investors to access the leveraged loan asset class in an efficient and targeted way and offer a wide array of securities across the risk spectrum. CLOs typically offer investors higher yields than comparably rated government and corporate bonds. Further, the floating interest rate payments (a spread above a benchmark rate) provide higher income in rising interest rate environments than fixed rate instruments. CLOs employ a variety of mechanisms to limit, detect, and correct any deterioration of underlying loans. Moreover, a typical CLO holds over 200 individual leveraged loans that are spread across many different industries. This high level of diversification helps mitigate the default risk of any single company or industry. In short, CLOs are but another tool for diversified return enhancement. What are the risks of CLOs? With any investment strategy, there is investment risk. Some risks of CLOs include: • Complexity: CLOs are complex investment vehicles that have unique features which are briefly outlined above. The various tranches have different levels of risks, while payments to investors follow a specific priority schedule. As such, it is recommended that investors conduct proper due diligence before investing in a CLO product. • Credit Risk: By their nature, CLOs are exposed to the credit risk of the underlying loans. If the underlying loans default – meaning, the borrow fails to repay the loan – then this can result in losses for investors. • Prepayment Risk: Though this may not seem at first to be a risk, in the event the underlying loans are paid in full before their maturity date, investors may miss out on potential future interest income. • Reinvestment Risk: As the fund receives cash proceeds from interest and ultimately full payments on the underlying loans, the fund manager may reinvest this cash into additional loans for a specified period of time. There is a risk, however, that newly purchased loans may not generate as much cash flow as the original loans.

• Cover