Where is the Arbitrage Opportunity for the Equity Investor?
The subordination of equity to debt and junior debt to senior debt in a CLO concentrates the risk of loss in the unrated equity and allows the CLO debt to be issued with higher ratings and a lower interest rate than the CLO portfolio would otherwise support. As a result, the CLO borrows at a lower rate than it earns on its assets. The positive “spread” between the interest earned on the portfolio and the interest paid on the CLO’s debt creates the arbitrage opportunity for the equity investor. The equity investor’s leveraged investment in the CLO portfolio allows for higher possible returns than an unleveraged investment in the same portfolio, but with commensurately greater risk of loss. What Variables Affect CLO Returns? How are Those Risks Mitigated or Managed? In addition to the cost of the liabilities and yield on assets, the key variables that affect the return to CLO equity investors are default rates, timing of defaults and recovery rates on the portfolio collateral. CLO expect
