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.
A Collateralized Loan Obligation CLO is a type of security that allows investors to purchase an interest in a diversified portfolio of company loans. The company selling the CLO will purchase a large number of corporate loans from borrowers such as private companies and private equity firms , and will then package those loans into a single CLO security. There are two main types of tranches used when selling a CLO: debt tranches and equity tranches.
Debt tranches, also called mezzanine, are those that offer the investor a specified stream of interest and principal payments, similar to those offered by other debt instruments such as debentures or corporate bonds. Equity tranches, on the other hand, do not pay scheduled cash flows to the investor, but instead offer a share of the value of the CLO if the CLO is re-sold in the future.
Within each of these categories, many different tranches might be available, with the riskier tranches offering higher potential returns. The main difference between them, however, is that CLOs are based on debts owed by corporations, whereas CMOs are based on mortgage loans. Guggenheim Investments. National Association of Insurance Commissioners. Accessed Aug. Alternative Investments. Real Estate Investing.
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These choices will be signaled globally to our partners and will not affect browsing data. The equity tranches pay the highest yield but carry the lowest credit ratings. The senior tranches provide the best credit quality but the lowest yield.
The mezzanine tranches fall somewhere between the equity and senior tranches in terms of credit quality and yield. The subject of mortgage-backed securities and collateralized debt obligations cannot come up without reference to the financial crisis of , which was largely caused by the collapsing value of mortgage-backed securities backed by subprime mortgages. The bubble in home prices was fed by subprime lending. Those subprime mortgages were packaged and sold on, to be repackaged and resold to institutions.
As the bubble began deflating, homeowners were forced into default, and the securities that derived an income from the repayment of those loans plummeted in value. The financial crisis eventually dissipated, and by the mortgage-backed securities market had returned to something like normalcy. Securities and Exchange Commission. Federal Deposit Insurance Corporation. Annual Review of Financial Economics. New York University. Accessed May 18, Government Publishing Office.
Alternative Investments. Real Estate Investing. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. But since CDOs enabled banks to sell on their mortgages to free up their balance sheets for more lending, they began lending to riskier customers in their search for more business.
This relaxation of lending standards into subprime mortgages - mortgages issued to borrowers with a poor credit rating - increased the eventual default rate of CDOs as people who could ill afford their mortgages stopped repaying them.
The danger is that the same appetite for CLOs may similarly reduce standards in leveraged lending. When homeowners failed to repay their mortgages and banks repossessed and sold their houses, they could recover substantial amounts that could be passed through to CDO investors.
However, companies are rather different to houses — their assets are not just bricks and mortar, but also intangible things like brands and reputation, which may be worthless in a default situation.
This may reduce the amount that can be recovered and passed on to CLO investors. In a recent paper , we examined the similarities between CDOs and CLOs, but rather than comparing their design, we examined legal documents which reveal the networks of professionals involved in this industry.
Actors working together over a number of years build trust and shared understandings, which can reduce costs. But the mundane sociology of repeat exchanges can have a dark side if companies grant concessions to each other or become too interdependent.
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