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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. Collateralized loan obligations are similar to collateralized mortgage obligations (CMO), except that the underlying loans are of a different type and character. With a CLO, the investor receives scheduled debt payments from the underlying loans, assuming most of the risk in the event borrowers default. In return for taking on the default risk, the investor is offered greater diversity and the potential for higher-than-average returns.

BREAKING DOWN 'Collateralized Loan Obligation - CLO'

A collateralized loan obligation is essentially a single security comprised of various corporate loans that have a low credit rating. The type of loans included in a CLO include 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 overall risk but they receive smaller interest payments as a result. 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.

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