CLOs: Benefits and Risks

Collateralized loan obligations (CLOs) are attracting increasing attention as investors broaden their horizons in the search for yield. While many investors know that CLOs have historically yielded attractive performance versus other fixed income strategies, they may not know the full extent of the benefits – as well as the distinct risks.

With CLOs, investors may benefit from the following:

Attractive performance. Over the long term, CLO tranches have outperformed other corporate debt categories, including leveraged loans, high yield bonds, and investment grade bonds, and have significantly outperformed at lower rating tiers.1

Wider yield spreads. CLO spreads have typically been wider than those of other debt instruments, reflecting CLOs’ greater complexity, lower liquidity for lower-rated tranches (while higher-rated tranches enjoy significant secondary market liquidity), and regulatory requirements. Compared with investment grade corporates, as well as other higher-yielding debt sectors – notably high yield and leveraged loans – CLO spreads are especially compelling.

CLOs Offer Higher Yields Versus Comparably Rated Corporate Bonds and Loans

Source: J.P. Morgan, Bloomberg, and LCD, as of 30 September 2024. US CLO debt represented by the J.P. Morgan CLOIE Index; IG credit: Bloomberg US Credit Index; High yield bonds: Bloomberg US Corporate High Yield Bond Index; Leveraged loans: Morningstar LSTA Leveraged Loan Index. Past performance is not indicative of future results.

Source: J.P. Morgan, Bloomberg, and LCD, as of 30 September 2024. European CLO debt represented by the J.P. Morgan Euro CLOIE Index; Euro IG credit: Bloomberg Euro Aggregate Corporate TR Index; EUR High yield bonds: Bloomberg Pan-Europe High Yield TR Index; Euro Leveraged loans: Morningstar LSTA European Leveraged Loan Index. Past performance is not indicative of future results.

Low interest-rate sensitivity. Leveraged loans and CLO tranches are floating-rate instruments, priced at a spread above a benchmark rate (such as SOFR and Euribor). As interest rates rise or fall, CLO yields will move accordingly, and their prices have historically moved less than those of fixed-rate instruments. These characteristics can be advantageous to investors in diversified fixed income portfolios.

An attractive risk profile. As demonstrated by a variety of key metrics, with default/impairment and loss rates as the most notable examples, CLOs have historically presented lower levels of principal losses relative to corporate debt and other securitized products.

Of the approximately $500 billion of US CLOs issued from 1994-2009 and rated by S&P (vintage 1.0 CLOs), only 0.88% experienced defaults, and an even smaller percentage of those, 0.35%, were originally rated BBB or higher (see table below). Among CLOs rated by Moody’s, there have been zero defaults on the AAA and AA tranches across all vintages (1.0 through 3.0).2

US CLO Default/Impairment Rates Have Been Low Historically

US CLO defaults by original rating (1994-Q1 2024)

Source: S&P Global, “CLO Spotlight: Thirty Years Strong: U.S. CLO Tranche Defaults From 1994 Through First-Quarter 2024.” Past performance is not indicative of future results.

Cumulative 10-year impairment rates

As of 25 June 2024. Source: Moody’s Investor Service. The multi-year cumulative withdrawn rating (WR) unadjusted impairment rates by original rating were reported June 2023 and covered 1993-2023 time horizon for Global CLOs, CMBS, US RMBS/HEL and Global Structured Finance, while Global Corporates represent the average cumulative issuer-weighted global default rates and covered 1983-2022 time horizon. Past performance is not indicative of future results.

Diversification. CLO correlations with other fixed income categories are relatively low, meaning that many CLOs have historically increased the effective diversification of a broader portfolio.3

Inflation and rising-rates hedge. CLOs’ floating-rate yields make them an effective hedge against inflation and rising interest rates since their coupons adjust based on a reference rate (SOFR or Euribor) and therefore have lower interest rate duration risk versus similarly rated fixed income alternatives.

Strong credit quality. Unlike most corporate bonds, leveraged loans are typically both secured and backed by first-lien collateral.

While there are many benefits, CLOs are complex investments. Naturally, they also present a number of risks that investors should consider carefully. These include:

Credit strength. While CLOs enjoy strong credit quality due to the senior secured status of leveraged loans, it’s important to keep in mind that leveraged loans carry inherent credit risk: They’re issued to below-investment-grade companies whose revenue streams are sensitive to fluctuations in the economic cycle.

The potential for collateral deterioration. If a CLO’s loans experience losses, cash flows are allocated to tranches in order of seniority. Depending on the severity of the losses, the value of the equity tranche could be wiped out and junior CLO tranches could lose principal.

Non-recourse and not guaranteed. Leveraged loans are senior obligations and, as such, generally have full recourse to the borrower and its assets in the event of default. A CLO, however, has recourse only to the principal and interest payments of the loans in the portfolio.

Loan prepayments. Leveraged loan borrowers may choose to prepay their loans in pieces or completely. While experienced CLO managers may anticipate prepayments, they’re nonetheless unpredictable. The size, timing, and frequency of prepayments could potentially disrupt cash flows and challenge managers’ ability to maximize portfolio value.

The potential for trading illiquidity. CLOs generally enjoy healthy trading liquidity, but that could change quickly if market conditions turn. A prime example is the financial crisis, when trading activity for even the most liquid debt instruments slowed to a trickle. While senior tranches are typically very liquid throughout a market cycle, lower-rated mezzanine tranches can see significant declines in trading activity during periods of severe market stress.

The timing of issuance. While market conditions could be strong when a CLO is issued, they might not be during its reinvestment period. We saw this with the 2003 vintages, whose reinvestment period coincided with the onset of the financial crisis in 2008 and its resulting drop-off in trading volume.

Manager performance. Historical performance of CLO managers encompasses a wide spectrum of returns, underscoring the importance of choosing seasoned managers with solid long-term track records.

Spread duration. While interest rate duration is low due to the floating-rate nature of CLO tranches (indexed off three-month SOFR and Euribor), spread duration should be taken into account. Due to CLOs’ typical reinvestment period of three to five years, spread duration is usually between 2.5 and nine years. Because each CLO is redeemed sequentially, the higher up the capital stack, the lower the spread duration (and vice versa), making spread duration higher in the lower-rated tranches.

To learn more about CLOs, read our full CLO primer, “Seeing Beyond the Complexity: An Introduction to Collateralized Loan Obligations.”