Wall Street Loves These Risky Loans. The Rest of Us Should Be Wary.

Right now, leveraged loans are some of the easiest products for financial firms to sell. Unlike most bond investments, which have fixed interest rates, leveraged loans typically have floating interest rates.

Floating-rate products do better than most bonds when interest rates rise, and those rates have been climbing. As long as rates continue to push higher, there will be a demand for leveraged loans.

But not everybody is thrilled with the idea of lending to already indebted companies, so financial engineers have transformed these loans into something more attractive.

The assembly line gets rolling again

C.L.O.s, which have been around since the mid-1990s, are a type of asset-backed security, which is, essentially, a kind of bond. But unlike a regular bond, in which a single company repays interest and principal to bondholders, they combine multiple repayment streams — thousands of monthly credit card, auto loan or mortgage payments, for example — and funnel them to investors.

Broadly speaking, here’s how it works. A C.L.O. manager buys a diverse bunch of leveraged loans and simultaneously lines up investors who are willing to buy a piece of this package. Each quarter, the indebted companies make payments on those loans, and that money is channeled to the end investors.

But C.L.O. investors aren’t all the same. They get to pick what is more important to them: low-risk returns or big payday potential.

Pitting a piece of the pie against patience

Let’s imagine that the proceeds from C.L.O.s are a pizza that arrives each quarter.

When it arrives, the investors have to form a line to see who eats first. That’s determined by the amount of risk they agreed to take on when they put in their money.

Article source: https://www.nytimes.com/2018/10/19/business/economy/clo-corporate-loans.html?partner=rss&emc=rss