CLOs provide an efficient, scalable way of investing in floating-rate loans while offering structural protection that has historically performed well through multiple credit cycles.
A collateralized loan obligation (CLO) is an actively managed securitized product backed by a highly diversified pool of leveraged loans. CLOs provide an efficient, scalable way of investing in floating-rate loans while offering structural protection that has historically performed well through multiple credit cycles.
To simplify, think of a CLO as a company that raises money from debt and equity investors to purchase a pool of 150–200 diversified senior secured first-lien corporate loans, "the assets." These assets are also called leveraged loans and come from large well-known borrowers, such as United Airlines, Virgin Media and Burger King, that have below investment grade ratings and high levels of debt. The loans are floating rate and pay interest on a monthly or quarterly basis with a spread above an index (typically SOFR or LIBOR). Additionally, the senior secured nature of these loans has resulted in historically higher recovery rates compared to senior unsecured bonds.
Juxtaposed with the assets are the debt obligations, or "the liabilities," which are sliced into "tranches" that re-distribute the risk of direct exposure to the portfolio of loans by offering tiered credit enhancement and structural protections. A typical CLO structure combines five or more classes, from the senior most tranche rated AAA down to the most junior and highest-yielding debt tranche rated BB-. The tranches are floating rate like the assets and are due a coupon on a quarterly basis.
After paying off expenses and liabilities, a residual unrated "CLO Equity" tranche captures the excess spread (returns) that the assets generate. As the equity tranche is leveraged exposure to the underlying leveraged loans, it is the riskiest piece of the CLO structure; however, it can also be the most lucrative.
