Collateralized Loan Obligation (CLO) Structure, Benefits, and Risks

Collaterized Loan Obligation (CLO)

Investopedia / Candra Huff

What Is a Collateralized Loan Obligation (CLO)?

A collateralized loan obligation (CLO) is a single security backed by a pool of debt. The process of pooling assets into a marketable security is called securitization. Collateralized loan obligations (CLO) are often backed by corporate loans with low credit ratings or loans taken out by private equity firms to conduct leveraged buyouts. A collateralized loan obligation is similar to a collateralized mortgage obligation (CMO), except that the underlying debt is of a different type and character—a company loan instead of a mortgage.

With a CLO, the investor receives scheduled debt payments from the underlying loans, assuming most of the risk in the event that borrowers default. In exchange for taking on the default risk, the investor is offered greater diversity and the potential for higher-than-average returns. A default is when a borrower fails to make payments on a loan or mortgage for an extended period of time.

Key Takeaways

  • A collateralized loan obligation (CLO) is a single security backed by a pool of debt.
  • CLOs are often corporate loans with low credit ratings or loans taken out by private equity firms to conduct leveraged buyouts.
  • With a CLO, the investor receives scheduled debt payments from the underlying loans, assuming most of the risk if borrowers default.
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Collateralized Loan Obligation (CLO)

How Collateralized Loan Obligations (CLOs) Work

A CLO is a bundle of loans that are ranked below investment grade. They are usually first-lien bank loans to businesses that are initially sold to a CLO manager and consolidated into bundles of 150 to 250 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. The order of the tranches dictates who will be paid out first when the underlying loan payments are made. It also dictates the risk associated with each investment since investors who are paid last have a higher risk of default from the underlying loans. Investors who are paid out first have lower overall risk, but they receive smaller interest payments, as a result. Investors 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, also called mezzanine tranches, are treated just like bonds and have credit ratings and coupon payments. These debt tranches come first in terms of repayment, and there is also a pecking order within the debt tranches.

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.

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.

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

CLO Structure

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.

CLO Process

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.

Each CLO has a fixed lifespan lasting several years. The first 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.

After the investment period closes, the CLO enters a period of reinvestment. The CLO manager can reinvest loan proceeds to improve the portfolio, either by buying additional collateral or selling poorly-performing loans.

At the same time, the CLO will also 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.

The last step is when 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.

Benefits of a CLO

A CLO is considered less risky than a single loan because it is unlikely that all of the loans in a CLO basket will default at the same time. Higher-ranked tranches are usually over-collateralized, meaning that they will still provide a return even if a number of the underlying loans fail.

CLOs are also actively managed by professionals who periodically buy or sell loans to balance the overall risk portfolio. Although management fees represent an added cost, capable managers can increase the overall performance of the security.

Risks to Consider

There are also important risks to keep in mind. The leveraged loans underlying a CLO are issued to companies whose credit rating is below investment grade. These companies, and their cash flows, tend to be more sensitive to market fluctuations. If the market moves against the borrowers, or the loans are paid off early, the debt investors may receive a worse-than-expected return.

It is also worth considering management experience. There are about 175 CLO fund managers, with varying track records. It is important to choose well-managed CLOs to ensure that your investment is in good hands.

Risky Asset?

Some argue that a CLO isn't that risky. Research conducted by Guggenheim Investments, an asset management firm, found that from 1994 to 2013, CLOs experienced significantly lower default rates than corporate bonds. Only 0.03% of tranches defaulted from 1994 to 2019. 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, or collateralized loan obligation, is a debt security backed by a pool of debt. Investors can choose one of several debt tranches to put their money into, with higher-risk tranches providing higher returns. Although yields may be higher than average, investors also assume the risk of borrower defaults.

Article Sources
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  1. Guggenheim Investments. "Understanding Collateralized Loan Obligations (CLOs)."

  2. National Association of Insurance Commissioners. "Collateralized Loan Obligations (CLOs) Primer," Pages 1-6.

  3. PineBridge. "Seeing Beyond the Complexity: An Introduction to Collateralized Loan Obligations."

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