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What Is a Collateralized Loan Obligation (CLO)?

Collateralized loan obligations (CLOs) are structured securities that bundle a pool of lower-rated corporate loans and sell them to investors in tranches. These investments, managed by CLO managers, offer an opportunity for investors to gain exposure to higher-than-average returns by assuming default risk. CLOs are similar to collateralized mortgage obligations in structure but differ mainly because they are backed by company loans rather than mortgages. Each tranche within a CLO has distinct risk-reward characteristics, with equity tranches offering higher potential returns at higher risk levels. This complex financial instrument allows investors to diversify their portfolios and potentially mitigate market volatility by investing in different tranches based on their risk appetite.

Key Takeaways

CLOs are securities backed by a pool of debt, typically corporate loans with low credit ratings, which are divided into different tranches to appeal to various investor risk appetites.

CLOs are divided into debt tranches and equity tranches, with debt tranches being paid first and carrying lower risk, while equity tranches offer higher potential returns but come with higher risk as they are paid out last.

CLOs are actively managed, allowing managers to buy and sell loans within the pool, which aims to optimize returns and minimize losses, offering diversity and potential for higher-than-average yields to investors.

Historically, CLO tranches have experienced lower default rates than corporate bonds, but they remain complex and are generally suited for large institutional investors due to inherent risks.

The creation of a CLO involves establishing a capital structure, raising capital, purchasing loans, and managing a special purpose vehicle to protect investors, culminating in repayment structured by tranches.

Investopedia / Candra Huff

Understanding the Mechanics of Collateralized Loan Obligations (CLOs)

A CLO consists of loans ranked below investment grade, typically 200 or more first-lien bank loans sold to a CLO manager. The manager then sells parts of the CLO, called tranches, to outside investors to fund new debt purchases.

CLO investors receive regular payments but assume higher risk if borrowers default, in exchange for potential higher returns and portfolio diversification. A default occurs when a borrower fails to make long-term loan payments.

Each tranche in a CLO determines payment order and risk level. Earlier tranches have lower risk and receive smaller interest payments, while later tranches involve higher risk but offer higher returns.

A CLO is an actively managed instrument: managers can—and do—buy and sell individual bank loans in the underlying collateral pool in an effort to score gains and minimize losses. In addition, most of a CLO's debt is backed by high-quality collateral, making liquidation less likely, and making it better equipped to withstand market volatility.

Exploring the Different Types of CLO Tranches

CLO tranches are of two types: debt (or mezzanine) tranches, which work like bonds with ratings and coupon payments, and equity tranches, which come second in repayment order.

Equity tranches, while unrated and typically yielding less immediate cash flow than debt tranches, offer ownership and potentially higher returns due to higher risk.

Important

CLOs offer higher-than-average returns because an investor is assuming more risk by buying low-rated debt.

Breaking Down the Structure of a CLO

A CLO consists of several debt tranches, ranked according to the creditworthiness of the underlying loans. The lowest tier is the equity tranche, representing ownership of the underlying collateral.

Structure of a CLO
 AAA Tranche  
 AA Tranche  
 A Tranche  
BBB Tranche  
BB Tranche  
Equity Tranche  

As the CLO enters the repayment phase, investors in higher-ranked tranches are paid first, followed by lower tranches. Lower-ranked tranches have higher risk profiles, but also higher potential returns. In the lowest tier, the equity tranche, investors receive any additional cash flow after the debt investors are paid.

Equity tranche investors also have a degree of control over the CLO that is not available to debt investors. For example, they have options to refinance the underlying CLO loans or reset the reinvestment period.

The Step-by-Step Process of Creating a CLO

Here's an over-simplied overview of how CLOs are created:

Step 1: Establish the Capital Structure. The first step to creating a CLO is establishing a capital structure, meaning the different levels of debt and equity underlying the security. A typical CLO has several debt tranches and an equity tranche, representing ownership of the underlying collateral.

Step 2: Seek Capital. The next step is to raise capital from investors, which is used to buy loans underlying the security. Each investor will contribute to a different loan tranche, with riskier tranches offering higher returns.

Step 3: Choose Tranches. As investors commit capital, they also have the opportunity to choose a tranche that meets their risk and return appetite.

Step 4: Purchase Loans. The CLO manager will use the capital from investors to buy loans. The CLO manager can reinvest loan proceeds to improve the portfolio, either by buying additional collateral or selling poorly-performing loans. At this stage, an underwriter analyzes the loan pool and assesses the creditworthiness of the borrowers. The underwriter also determines the appropriate structure and size of the CLO transaction.

Step 5: Create Special Purpose Vehicle. Most often, a special purpose vehicle (SPV) is created to issue the CLO securities. The SPV is usually designed to protect the investors in case of default.

Step 6: Pay Investors. Ultimately, the CLO will begin repaying investors with a spread that has been pre-determined for each tranche at the time of closing. Afterward, holders of the equity tranche can call or refinance the loan tranches. Eventually, the CLO begins to deleverage. As the underlying loans are paid off, the CLO manager will repay the investors, starting with the most senior tranche. Any remaining proceeds will go to the equity tranche holders.

Step 7: Termination. The CLO transaction may terminate when all of the securities have been repaid or when the underlying loans have been paid off or sold. At this point, any special purpose vehicles are dissolved and any remaining assets are distributed to the investors.

Key Advantages of Investing in CLOs

There are a variety of benefits of a CLO, including but not limited to:

Evaluating the Risks Involved with CLO Investments

With those benefits in mind, there are also a number of downsides to CLOs. Those risks include but aren't limited to:

Risky Asset?

Some argue that a CLO isn't that risky. Research conducted by Guggenheim Investments, an asset management firm, found that from 1998 to 2024, CLOs experienced significantly lower default rates and higher recovery rates than high-yield bonds. Even so, they are sophisticated investments, and typically only large institutional investors purchase tranches in a CLO.

In other words, companies of scale, such as insurance companies, quickly purchase senior-level debt tranches to ensure low risk and steady cash flow. Mutual funds and ETFs normally purchase junior-level debt tranches with higher risk and higher interest payments. If an individual investor invests in a mutual fund with junior debt tranches, that investor takes on the proportional risk of default.

What Is a Collateralized Loan Obligation (CLO)?

A Collateralized Loan Obligation (CLO) is a type of security that allows investors to purchase an interest in a diversified portfolio of company loans. The company selling the CLO will purchase a large number of corporate loans from borrowers such as private companies and private equity firms, and will then package those loans into a single CLO security. The CLO is then sold off to investors in a variety of pieces, called “tranches”, with each tranche offering its own risk-reward characteristics.

What Is the Difference Between a Debt Tranche and an Equity Tranche?

There are two main types of tranches used when selling a CLO: debt tranches and equity tranches. Debt tranches, also called mezzanine, are those that offer the investor a specified stream of interest and principal payments, similar to those offered by other debt instruments such as debentures or corporate bonds.

Equity tranches, on the other hand, do not pay scheduled cash flows to the investor, but instead offer a share of the value of the CLO if the CLO is re-sold in the future. Within each of these categories, many different tranches might be available, with the riskier tranches offering higher potential returns.

What Is the Difference Between a CLO and a Collateralized Mortgage Obligation (CMO)?

CLOs are similar to Collateralized Mortgage Obligations (CMOs), in that both securities are based on a large portfolio of underlying debt instruments. The main difference between them, however, is that CLOs are based on debts owed by corporations, whereas CMOs are based on mortgage loans. Both CLOs and CMOs are examples of credit derivatives.

The Bottom Line

A CLO is a debt security backed by pooled loans. Investors can select tranches based on their risk-return preference: higher-risk tranches offer higher returns, but also higher default risk.

This article is not intended to provide investment advice. Investing in securities entails varying degrees of risk and can result in partial or total loss of principal. The trading strategies discussed in this article are complex and should not be undertaken by novice investors. Readers seeking to engage in such trading strategies should seek out extensive education on the topic.