Collateralized Loan Obligation (CLO)

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.

How Collateralized Loan Obligations (CLOs) Work

Loans — usually first-lien bank loans to businesses — that are ranked below investment grade are initially sold to a CLO manager who bundles (generally 150 to 250) 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. 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, which as also called mezzanine 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.

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.

Special Considerations

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 have 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.