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Collateralised Loan Obligation

A form of securitised debt where a portfolio of loans, usually to businesses, is packaged together and then sold off in tranches.

The highest ranking tranche (the one that gets repaid first) may be rated as AAA or equivalent; that is to say, in the opinion of a rating agency, the chances of losing money on the AAA portion are the same as the chances of losing money lent to any other AAA rated borrower, like a well-financed government.

Below the AAA tranche, which is usually by far the largest, are a series of lower ranking tranches and the lowest is often called the equity tranche because it is as risky as holding highly geared equity.

The interest rate paid on the AAA tranche should be consistent with the interest rate paid on any other AAA rated security and this and the interest payable on other higher ranking tranches should be well below the interest being paid to the Collateralised Loan Obligation by the borrowers. This means the interest rates on the lower rated tranches can be a lot higher (but, to large extent, this just compensates them for the extra risk involved in holding the lower rated tranches since they bear the first losses in the portfolio if a borrower or borrowers cannot repay their loans.

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