Why do investors in senior bond classes of a CLO earn higher yields than comparable corporate bonds?
Q number 6 in picture
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I was a Quant Dev on the CDO desk at Lehman Brothers in 2008…
Here are factors that are true to all structured products (including CLOs):
- Combining elements of several financial instruments makes structured products tricky to monitor across changing market environments.
- Structured products are bespoke, so they are often tough to resell.
- Banks are the main providers of structured products, exposing investors to significant counterparty risks. (I saw this first hand at Lehman Brothers – many of our CDOs / CLOs SPVs suffered greatly when Lehman defaulted and couldn’t perform its functions)
- The cost structure of these instruments is opaque.
Because of the above factors (and other factors), investors in CLOs typically demand a higher yield than on comparably rated corporate bonds.
Adding to Xavier’s excellent reply above, I would add that typically, gearing is higher in a CLO tranche compared to a corporate of same rating.
So typically say the AAA will be perhaps 60-65% LTV in CLOs, while you’re probably sub 10% in a corporate of that rating.
The math works, in the sense that the LGD in CLO AAA is close to 0, but almost by construction, you’re more exposed to tail risk.
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