Despite superficial similarities, CLOs and SRTs don’t have much in common

Syndication. Whereas CLOs are asset manager-sponsored and advised transactions that issue rated debt in the broadly syndicated capital markets, SRTs notionally segregate assets on a bank balance sheet and then distribute the lower-rated tranches (typically equity) to investors. They are not broadly syndicated.

Complexity. CLO equity has become more transparent and accessible to investors, such as hedge funds, asset managers, sovereign wealth funds, and even sophisticated retail investors. In contrast, SRT transactions remain opaque, institutional-only products due to their complexity, execution risk and regulatory considerations.

Motivation. CLO managers sponsor and organise fee-paying transactions to expand an investment management platform, with the more successful increasing AUM and fee income. Bank SRT issuers are typically motivated by the desire to free up regulatory capital by reducing risk on portfolios of assets. First-loss protection provides the bank-retained portion with credit enhancement, resulting in lower regulatory capital, which can be redeployed. SRTs are not managed for the benefit of the investor.

Net or premium income. CLO investors benefit from the manager’s efforts to create value through asset selection and trading. CLO income is comprised of portfolio yield minus the cost of financing, fees, expenses and monetised asset gains or losses.

Investors may choose to approve a refinancing or a reset that extends the reinvestment period or reduces the cost of funding. The investor can see its distributions change significantly as the difference between asset and liability spreads changes.

SRT investors receive a negotiated — yet very stable — premium multiplied by the notional amount of the equity invested. The negotiation of the premium is derived from several inputs, including the bank’s overall cost of capital and the risk profile of the portfolio. Importantly, the SRT premium is not impacted by any spread differential or asset appreciation in the underlying portfolio.

Reinvestment and replenishment. CLOs and SRTs have a designated period during which the manager or bank can trade assets or replenish assets in the event of a prepayment, refinancing or cash-settled default. In reinvestment and replenishment periods, the manager or bank will add new assets in exchange for cash received.

CLO managers possess broad discretion to acquire assets. But SRT substitution rights are highly negotiated and clearly defined by closing. Once the rules are set, replenishment is left to the bank’s discretion. As an arm’s length party, the bank is not obligated to act in the investor’s best interests. When assessing a transaction, SRT investors should assume that the bank will aim to maximise its ability to hedge exposure during replenishment, especially in times of credit stress, and that the selected asset may not favour the transaction.

Event of loss. Events of loss impact the structures quite differently. For a CLO, the equity absorbs any losses that result from either trading or default. Loss-making sales can significantly degrade CLO equity value. Consequently, managers are loath to sell positions that crystallise a loss. Conversely, CLOs benefit from the sale of appreciated assets and other ‘par building’ transactions, allowing managers to offset losses. Many managers actively trade portfolios to benefit CLO equity.

Many SRTs limit losses to traditional credit events. Often, distressed sales are not considered events of loss and do not impact the transaction value. The structure is intended to protect the bank against default, not changes in the market value of the loans.

Trade termination. Both types of deal begin to amortise following the termination of the reinvestment or replenishment periods, and each has a stated legal maturity. However, CLOs are often reset, extending the actual term by many years. But when the transaction reaches its final maturity, or is called by the CLO equity, the assets are liquidated at their current market value, subjecting the CLO equity to a potential return of less than par. Accordingly, CLO equity investors consider their coupon payments the primary component of total return.

SRT transactions have a stated legal final at which the transaction terminates with all assets not then currently in default (or recovery) returning to the bank balance sheet, ignoring any market value changes. This means SRT investors focus primarily on defaults and, more importantly, the timing of defaults.