Current tax issues in the collateralized loan obligation markets

Overview

Over the last decade, the issuance of corporate and leveraged loans has grown to record levels. A large percentage of these loans are currently owned by securitization structures called collateralized loan obligations (CLO). CLO entities issue several tranches of senior and subordinated securities. Payments on these securities are made from cash flows generated by the underlying collateral (i.e. the loan investments). The CLO securities typically are held by institutional investors, such as insurance companies, pension funds, mutual funds, and hedge funds, among others. 

During the 2008 financial crisis, CLO securities often performed better than other securitized debt products. With the anticipated downgrades of corporate loans in today’s markets, the performance of CLOs could face pressure.  Specifically, the performance of CLO securities is dependent on the performance of the CLO’s underlying loan collateral. Defaults, forbearances, recoveries, restructurings and other events that affect the cash flow of the CLO collateral impact the performance of CLO securities. In addition, some events that do not affect cash flow can impact the performance of CLO securities. For example, downgrades of the issuers of underlying loans can cause payments to be diverted from holders of lower tranche CLO securities to senior CLO tranches. 

The taxation of CLO securities is tied to the CLO tranche structure. In most CLOs, all but the most subordinated securities are treated as debt for tax purposes (in this Insight, the term for such securities, Senior Notes, includes senior, mezzanine, and junior CLO tranches). These various tranches of Senior Notes have varying degrees of credit risk, with the most senior tranches having the lower risk and the junior tranches having higher risk. The most subordinated, and riskiest security, is typically called the subordinated notes (Subordinated Notes) and is treated as equity ownership in the CLO for tax purposes.

The takeaway

Tax accounting for CLO Senior Notes and Subordinated Notes during difficult economic times creates complex tax issues, only some of which are briefly highlighted in this Insight. The issues are broad and impact operations, after-tax returns, liquidity, and distributions. Although the markets are moving fast, being prepared with the appropriate policies, operations, and systems may help to alleviate some of the issues and reduce tax risks.