CLOs Versus CDOs: What’s the Difference?

Among even sophisticated investors – and certainly in business press coverage – the complexity of collateralized loan obligations (CLOs) creates a sense of wariness. All too often, people confuse them with a similar sounding security: collateralized debt obligations, or CDOs.

So what’s the difference?

CDOs earned a great deal of notoriety after the financial crisis, and rightly so. The CDOs in question were based on mortgages, and many of these loans were made to borrowers who, ultimately, couldn’t afford to make their monthly payments. This created shortfalls in the cash flows into CDO structures, leading to high levels of default throughout the CDO market. The lack of regulation leading up to the financial crisis contributed to these defaults.

CLOs, in contrast, are backed by corporate credit in the form of leveraged loans. The leveraged loan market is regulated and loans cannot come to market with a leverage ratio of more than 6x. Unlike CDOs, CLOs have exhibited very low levels of default – in fact, no AAA or AA rated CLO tranche has ever defaulted. Additionally, each credit is analyzed individually by hundreds of analysts at firms around the globe who seek to hold the borrowing company to its covenants. With CDOs, on the other hand, individual mortgage loans were not studied line by line before the crisis. While we agree that we are seeing more aggressive leveraged loan structures coming to market with overly positive add-back assumptions, we are comfortable with the CLO transactions we choose and the leveraged loans backing them.

So how do analysts like us get comfortable with the loans backing a CLO?

When we look at a CLO tranche investment, we re-underwrite the portfolio by mapping each credit to our proprietary system. We conduct considerable due diligence on the CLO manager, seeking to understand its record and default/recovery history in leveraged loans. Due to our experience in issuing and managing CLOs, we understand structure and documentation particularly well. We have been issuing and managing CLOs in the US since 1999, and our track record in leveraged loans goes back to 2001.

Understanding what CLOs are, how they work, and the true nature of their risks and rewards can be helpful in making a more informed decision about their role in an investor’s portfolio.