Collateralized Loan Obligation - CLO

Loading the player...

What is a 'Collateralized Loan Obligation - CLO'

A collateralized loan obligation (CLO) is a security backed by a pool of debt, often low-rated corporate loans. CLOs are similar to collateralized mortgage obligations, except for the different type of underlying loan. With a CLO, the investor receives scheduled debt payments from the underlying loans, assuming most of the risk in the event borrowers default, but is offered greater diversity and the potential for higher-than-average returns.

BREAKING DOWN 'Collateralized Loan Obligation - CLO'

A CLO is essentially a single security comprised of various corporate loans that have a low credit rating. An example of the type of loans included in a CLO is leveraged buyouts made by a private equity firm to take a controlling interest in an existing company.

How CLOs Are Structured

Loans with lower credit ratings are initially sold to a CLO manager, who bundles multiple loans together and manages the consolidations, actively buying and selling loans. To fund the purchase of new debt, the CLO manager sells stakes in the CLO to outside investors in a structure called tranches. Each tranche is a piece of the CLO, and it dictates who will be paid out first when the underlying loan payments are made. It also dictates the risk associated with the investment, since investors who are paid last have a higher risk of default from the underlying loans. People who are paid out first have lower risk but realize smaller interest payments. People who are in later tranches may be paid last but the interest payments are higher to compensate for the risk.

There are two types of tranches: debt tranches and equity tranches. Debt tranches are treated just like bonds and have credit ratings and coupon payments. These debt tranches are always in the front of the line in terms of repayment, although within the debt tranches there is also a pecking order. Equity tranches do not have credit ratings and are paid out after all debt tranches. Equity tranches are rarely paid a cash flow but do offer ownership in the CLO itself in the event of a sale.

The Risks of a CLO

Typically, only large institutional investors purchase tranches in a CLO. This means 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.

RELATED TERMS
  1. Sequential Pay CMO

    A type of collateralized mortgage obligation (CMO) in which there ...
  2. Tranches

    A piece, portion or slice of a deal or structured financing. ...
  3. Active Tranche

    A tranche of a collateralized mortgage obligation (CMO) that ...
  4. Asset-Backed Security - ABS

    A financial security backed by a loan, lease or receivables against ...
  5. Companion Tranche

    A class of tranche found in planned amortization class (PAC) ...
  6. Accrual Bond

    A bond that does not pay periodic interest payments. Instead, ...
Related Articles
  1. Investing

    What are Tranches?

    Tranches often describe specific classes of bonds within a security that hold different degrees of risks and maturities.
  2. Investing

    What Are Tranches?

    “Tranche” is a French word that refers to a slice.
  3. Markets

    As Regulators Target CLOs, Bankers Predict Doom For Main Street

    Collateralized loan obligations are the latest Wall Street invention to give regulators headaches.
  4. ETFs & Mutual Funds

    CMO vs CDO: Same Outside, Different Inside

    The concept of collateralizing and structured financing predates the market for collateralized mortgage obligations and collateralized debt obligations.
  5. Markets

    The Return of CDOs After the 2008 Financial Crisis

    Learn how the market for CDOs is coming back after the 2008 financial crisis, and understand how the market for these products has changed.
  6. Investing

    Profit From Mortgage Debt With MBS

    Mortgage-backed securities can offer monthly income, a fixed interest rate and even government backing.
  7. Investing

    Exploring Real Estate Investments: Buying And Owning Real Estate

    By Ian Woychuk, CFA In Chapter 2, we presented the investment selection matrix, which outlines your alternatives when choosing the kind of real estate investment to make. You can choose to invest ...
  8. Retirement

    Collateralized Debt Obligations: From Boon To Burden

    CDOs were to be Wall Street's boon - instead they went bust. Find out what went wrong.
  9. Investing

    A Primer On Collateralized Debt Obligation (CDOs)

    A collateralized debt obligation, or CDO, is a structured financial product backed by a pool of loans. When a retail or commercial bank approves loans such as mortgages, auto loans or credit ...
  10. Investing

    Debt Consolidation: When It Helps, When It Doesn't

    Here's the smart way to use a debt consolidation to get your financial life back on track
RELATED FAQS
  1. Who bears the risk of bad debts in securitization?

    Bad debts arise when borrowers default on their loans. This is one of the primary risks associated with securitized assets, ... Read Answer >>
  2. What's the difference between a collateralized debt obligation (CDO) and a collateralized ...

    Find out how a collateralized mortgage obligation (CMO) is similar to a collateralized debt obligation (CDO), as well as ... Read Answer >>
  3. What's the difference between a collateralized mortgage obligation (CMO) and a mortgage-backed ...

    Find out more about collateralized mortgage obligations and mortgage-backed securities and the difference between the two ... Read Answer >>
  4. What is the difference between a collateralized mortgage obligation (CMO) and a collateralized ...

    Both collateralized mortgage obligations (CMOs) and collateralized bond obligations (CBOs) are similar in that investors ... Read Answer >>
  5. Which loan should I pay off first?

    I have a $33,000 mortgage at 4.5% interest due in June 2019. I also have $627 in monthly car loan payments for loans that ... Read Answer >>
  6. What are some examples of debts that I can consolidate?

    Read about different kinds of debts than can be combined into a consolidation loan, including unsecured debts, secured debts ... Read Answer >>
Hot Definitions
  1. Glass-Steagall Act

    An act the U.S. Congress passed in 1933 as the Banking Act, which prohibited commercial banks from participating in the investment ...
  2. Quantitative Trading

    Trading strategies based on quantitative analysis which rely on mathematical computations and number crunching to identify ...
  3. Bond Ladder

    A portfolio of fixed-income securities in which each security has a significantly different maturity date. The purpose of ...
  4. Duration

    A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. ...
  5. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
  6. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
Trading Center