Inside CLOs: How Risk, Return & Credit Really Work in Finance

Hello everyone, my name is Dalia D'Agustino, and welcome to FinTech TV.

I'm pleased to welcome Wynne Comer, Chief Operating Officer of AGL Credit Management, one of the leading firms in the world of CLOs and corporate credit.

Thank you for joining me.

Thanks for having me.

A few years ago I started a YouTube channel dedicated to teaching financial literacy to kids.

Now, thanks to the wonderful team at FinTech, I have the chance to interview inspiring business leaders and hear their thoughts on money, the future of finance, and advice for young people just starting their financial journey.

Let's begin now.

We, I'm not gonna lie, I'm a little nervous for this interview.

I've interviewed close to a dozen people on many topics like cryptocurrency, but what you do is definitely the most complicated.

So what I wanna do is give a metaphor for CLOs, and I want you to correct me.

Great.

CLOs or collateralized loan obligations are kind of like a tiered cake.

The people in the front of the line get the first piece.

It's the smallest piece, but, but for the most part, they know they're going to get it.

The people in the back have the opportunity to get the biggest piece at the bottom, but they also have the risk of not getting any if the cake drops.

This is kind of like CLOs where you loan out money.

So I love the metaphor.

I'm going to think of it as something a little bit different, which is more like a layered cake, but horizontally.

Where the people at the top get the get the biggest slice of the structure, and they get to eat as much as they want, but there's more leftover, but there's a chance for the people at the bottom, who are all the way at the bottom, not to get anything, or to get less than they thought.

Oh, yeah, um, I mean, you're the expert here.

Do you, do you think, how would you explain COLOs to kids?

So, um, CLOs do seem complicated, but like a lot of finance, they got complicated over time.

So, I would start with what are loans.

Loans are really a way for companies or individuals to borrow money, and originally banks would lend 100% of the loan to a company at a time.

In order to make sure that they didn't lose all their money, they would charge an interest rate and then some amount of risk premium to take account of the fact that there, there's a little bit of risk lending hundreds of millions dollars to one company.

Over time, they realized that they could syndicate, meaning they could sell a portion of their bank loans to very excited institutional investors like insurance companies, asset managers.

And by diversifying their risk and and lowering the the individual holdings of each of those bank loans, they were able to reduce the rate to the borrowers, which work for the borrowers too.

So that was one big step, is syndicating the bank loans.

COs are just another example of that, kind of your example of the cake going vertical versus horizontal.

COs are an example of ways to syndicate the risk into more and more.

Uh, institutional fires.

So, it's still the same underlying product.

It's still bank loans, it's just much more diversified portfolios of bank loans spread among a lot of different buyers.

Um, I think what might be helpful is to think about why CLOs are different from just a mutual fund.

Um, a mutual fund, everybody has the same risk in the same pool.

CLOs, um, Divide up the risk by who gets the first bite of the cake to who gets the last opportunity to have a bite of the cake.

So, the people at the front of the line.

Um, are guaranteed the right of, of eating that cake.

Um, so they get the lowest interest rate and the highest rating, which is something that rating agencies give to show different amounts of risk.

As you go down, there's 4 to 5 to 7 different tranches, and each one kind of stands in line for that opportunity to to get their return.

OK, uh, my question is, why would somebody want the lowest job? what type of investor would want that?

So, um, we have so many different types of investors because the, the beautiful thing about COs is you can really tailor your appetite, keeping with your metaphor to, um, to the risk that you want to take and the return you want to get.

So, Banks um are looking for interest income, so they will invest in leveraged loans by themselves, or they can invest in AAA's, which is, um, a diversified pool of leverage loan underlying the CLOs, but take the, the uh lowest amount of risk.

So the return is really good from a risk return kind of perspective.

They're getting a AAA rated note.

And uh today, it would be something like sour, which is a floating interest rate, plus 1.2% above that.

That's a great risk.

Or you might have somebody like a hedge fund who's saying, you know what, I actually really like the mezzanine, the middle of the stack.

I want something more like sofa plus 500.

And then finally, the equity, which is really the bottom of the capital structure that has lots of different types of investors who are interested in in a pretty high returning piece of paper.

Um, looking back at her childhood, was there a moment with money or a job where you first realized that some risks get paid more than others?

And how does that idea show up in the work you do with CLOs today?

Uh, that's a great question.

Um, my first job out of college was working, um, in Japan in project finance.

And it was a great training, uh, ground for me because project finance is really, um, putting together a construction project, typically, and then thinking about all the different risks that exist within that, um, project.

So, who's going to build that project?

Let's just say it's an automobile factory.

Who's going to build it?

Uh, and what kind of risks do they have?

Who's going to operate it, and what kind of risks do they have, and then finally, who's going to pay for it, and what kind of risks do they have.

So, um, that was a really good way for me to learn about risk, and I think all of my jobs after that have been kind of thinking about who's taking the risk and who's getting the return.

Um, I know you work a lot with CLOs, and I know they're a really confusing topic, um.

Can you, um, and I already explained to, I already explained them in a way a kid my age will understand, but can you, you know, explain more the different tiers, what they actually mean, like people that invest in them?

Sure.

So, um, a CLO, again, the underlying is just a diversified portfolio, let's say 350 to 400 different individual pieces of bank loans.

So for a Um, you know, a $500 million transaction, you would have, say, you know, $2 million to $2.5 million to $4 million of individual loans, so very diversified loan.

When you think about how the deals come together, the, um, the buyers of the CLO securities, um, a large part of the of the buyers, say 60% of the buyers, um, have the right at the top level, this at the AAA level.

So, those buyers, when the interest on the loans of the portfolio comes in, those buyers have the first right.

For the, the loan interest payment, and they will get all of their interest first before the next tranche, which is the AA tranche.

The ratings are typically set up AAA, AA, A, 3BB, BB, and then the residual, meaning after all the debt tranches are paid, the residual tranche gets the right for everything else.

So, when you think about it, the, the The interest on the underlying loans is enough to pay all of the debt tranches, all of those 7 different debt tranches, and then leave a very, very good return for the equity tranche.

And importantly, that's after payment of fees, that's after some modeling of defaults and recoveries on the underlying portfolio, because you want to make sure that you've thought about everything.

You want to make sure that you've built the structure to be very, very, um, safe, and um secure, to make sure that you have that that residual left for the equity buyer.

If a kid wanted to start understanding the world of credit and loans the way you do, what is one concept you wish someone had explained to you at my age that would have given you a good head start?

I mean, I think kids are pretty smart about different risks in your lives.

I mean, I think when you're, this is, I'm gonna, I'm gonna jump to a metaphor, but when you're thinking about how you, how you allocate your time, right?

You have so many tests coming up, you have only a limited amount of time.

You're constantly thinking about how to manage that, you know, those that limited time to make sure you're studying for each of your, your, um, tests, and sometimes you don't have enough time, but you know how to kind of balance.

What you really need to focus on versus what you kind of maybe can't get perfect.

Um, I think in terms of credit.

What I really like about credit is Um In all aspects of it, you're kind of solving a problem, right?

Bank loans are giving money to a company to do something important for them.

They're building a factory, they're acquiring another company, right?

So that's a very um mutually beneficial relationship.

Banks are getting a good interest rate uh back to them and building a relationship with that with that client.

In terms of CLOs, It's really solving a problem between the underlying buyers, which go back through the banks to the underlying companies.

Those buyers, those companies are able to borrow at a lower rate than they would be able to if it was just a bank lending hundreds of millions of dollars, right?

By syndicating the risk, by diversifying the risk, they get a lower rate that they're borrowing at.

The buyers of the CLO securities, you're actually working with a lot of, you know, individual institutional investors who need something.

They need a good return for their money.

So, sometimes a buyer might say, given my risk appetite, I only want to focus today on lower risk security.

So that's the triple AAA security.

Or they might say, you know what?

I feel really good about about where my overall portfolio is, and I want to take a little bit more risk and get a little bit more return.

So it's an incredibly collaborative kind of way to work with.

Institutional investors, borrowers through the banks, and make the whole system work for everybody.

So prioritizing is one of the most important.

Yes.

When a CLO is built, the senior tier gets paid first and the equity tier gets paid last.

What does that arrangement teach kids about the relationship between safety, patients, and in finance?

That's a great question.

Yes, I think it's, I think, um, nothing's for free, right?

So, if you think about, um, something that uh sounds too good to be true, there's typically risk involved, right?

So you have to think about the risk.

Why would something be offered a 15% return?

So, you invest 100, you're getting back 115, you know, that's on time zero.

Why, why would somebody give that opportunity to you?

So that makes you think about.

What could go wrong?

Why would that 115 not not be back at you?

Like, why would it be less sometimes?

Why would it be more sometimes?

So, I think it's um It's a good way for kids to start thinking critically.

About the whole picture.

Why does it work?

Why does it not work to try to understand why, why it works.

Um, CLOs have been around since before 2000, uh, because they've worked incredibly well.

They are complicated, so it takes a lot of time to, to understand them, but they've worked because it, it does work for all parties of the transaction.

Uh, you said 2, you said 2000, that's relatively new.

Um, the last question is, adults often talk about how money is changing and, and finance is changing.

Um, do you think CLOs are gonna change with that, or do you think they're gonna mostly stay the same?

Um, I think the structure of CLOs has actually been done in many different asset classes.

It's actually the same concept of mortgages and mortgage backed securities.

Same concept that banks lend money to individuals to buy houses, and then those get packaged up and sold to different institutional investors.

That concept of 1st, 2nd, 3rd, 4th, 5th risk and Uh, lowest return to highest return has existed for hundreds of years.

So I think that, um, CLOs will continue to evolve as um different asset classes come into, um, into effect.

So, Originally it was sort of, you know, only bank loans, only broadly syndicated bank loans.

Then it was a little bit more, you know, smaller loans to smaller middle market companies.

Now it's more private credit, which is sort of the same thing, but there's things like infrastructure, CLOs, CDOs, um, which are more infrastructure projects.

So, it'll continue to evolve, um, but it's a very proven structure, so I think the basics will stay the same.

Well, um, that's the end of my questions.

Thank you so much for joining us.

Thank you so much for having me.

I hope you and everyone watching has a great day.

Thank you.