CLOs: How They Work

Collateralized loan obligations (CLOs) are attracting increasing attention as investors broaden their horizons in the search for yield. While CLOs have historically yielded attractive performance versus other fixed income strategies, some investors may be intimidated by their complexity.

What is a CLO?

A CLO is a portfolio of predominantly leveraged loans that is securitized and managed as a fund. Each CLO is structured as a series of “tranches,” or groups of interest-paying bonds, along with a small portion of equity, which receives excess payments.

CLOs have changed a lot over the years, getting better with age. The current vintage, CLO 3.0, began in 2014 and aimed to reduce risk by eliminating high yield bonds and adhering to the Volcker Rule and other new regulations. In 2020, the Volcker Rule was further amended, and high yield bonds were allowed back into CLOs. However, they tend to make up only a small portion of CLO assets – typically 5%-10% – and those transactions benefit from higher levels of subordination to compensate for the lower recovery rates historically observed when a high yield bond defaults.

The vast majority of CLOs are called arbitrage CLOs because they aim to capture the excess spread between the inflows from payments of interest and principal on the leveraged loans and the outflows of management fees and interest paid on the tranches, among other costs. The portfolio consists predominantly of leveraged bank loans (assets) and the classes of CLO debt (liabilities), with the equity investors receiving any excess cash flows after the debt investors are paid. The market for arbitrage CLOs is valued at $1.29 trillion globally, with about 81% issued in the US and 19% in Europe.1

What are leveraged loans, and what part do they play in CLOs?

Leveraged loans are more than simply the underlying collateral for CLOs: They’re the fuel that powers CLOs’ historically attractive income streams and the first of several levels of potential risk mitigation built into the CLO structure.

S&P defines leveraged loans as senior secured loans rated BB+ or lower (i.e., below investment grade) or yielding at least 125 basis points above a benchmark interest rate (typically SOFR in the US and Euribor in Europe) and secured by a first or second lien.2 Several characteristics make leveraged loans particularly suitable for securitizations. They:

• Pay interest on a consistent monthly or quarterly basis;

• Trade in a highly liquid secondary market;

• Have a historically high recovery rate in the event of default; and

• Originate from a large, diversified group of issuers.

As of 30 September 2024, the amount of leveraged loans outstanding was $1.39 trillion in the US and €295 billion in Europe.3

Who issues, manages, and owns CLOs?

CLOs are issued and managed by asset managers. Of the approximately 225 CLO managers4 with post-crisis deals under management worldwide, PineBridge has found that about two-thirds are in the US and the remaining third are in Europe.

Ownership of CLOs varies by tranche. The senior-most tranches are mainly owned by insurance companies (which favor income-producing investments) as well as banks (which need high-quality capital to meet regulatory requirements). The equity tranche is the riskiest of the typical tranches, offering potential upside and a degree of control, and appeals to a wider universe of investors.

How do CLOs work?

CLOs combine multiple elements with the goal of generating attractive returns through income and capital appreciation. CLO tranches are ranked highest to lowest in order of credit quality, asset size, and income stream – with the lowest tranche taking the greatest amount of risk, in comparison to the tranches above it in seniority.

Tranches Allocate Assets, Income, and Risk

Typical CLO tranche structure

Source: Citibank as of 30 September 2021.

Although leveraged loans themselves are rated below investment grade, most CLO tranches are typically rated investment grade because they benefit from diversification, credit enhancements, and subordination of cash flows.

Cash flows are the lifeblood of a CLO: They determine the distribution of income and principal, which determines the return on investment. The key concept is that distributions are paid sequentially starting with the senior-most tranche until each CLO tranche has been paid its full distribution. Equity-tranche holders absorb costs and receive the residual distributions once the costs have been paid.

How do CLOs aim to mitigate risk?

Typically, CLOs have covenants that require the manager to test the portfolio’s ability to cover its interest and principal payments monthly. Coverage tests are a vital mechanism to detect and correct collateral deterioration, which directly affects the allocation of cash flows. Among the many such tests, the most common are the interest coverage5 and overcollateralization6 tests.

If the tests come up short, the manager must take cash flows from the lowest debt and equity-tranche holders and divert them to retire CLO tranches in order of seniority.

Coverage tests are one of several risk protections built into the CLO structure. Others include collateral concentration limits, borrower diversification, and borrower size requirements.

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