Managing Collateralized Loan Obligations

Collateralized loan obligations (CLOs) are a type of securitized debt instrument that has gained significant traction in recent years. Over the past decade, the market has grown significantly. As of September 2023, the leveraged CLO debt market stood at $970 billion, with $527 billion in outstanding AAA CLOs. Today’s size of the CLO market represents a more than three-fold increase from a post-financial crisis low of $263 billion.¹

The asset class is viewed as a reliable investment that connects companies seeking financing with investors on the hunt for higher yield. CLOs also serve as a haven from rising interest rate volatility due to their floating rates. The opportunity to diversify investments and safeguard cash flow further adds to their intrigue.

CLOs are appealing for several reasons:

• Attractive risk and return profile, even in the face of market expectations for a slight uptick in default rates²
• Portfolio diversification and stable cash flow
• Market opportunity as banks seek to divest in CLOs and as private credit and investment management firms seek new opportunities

What is a CLO? 

A CLO is a structured finance product that pools together a portfolio of corporate loans, typically senior secured loans, of non-investment grade borrowers. The loans are then securitized into different instruments of varying risk and credit ratings and divided into different tranches, each with varying levels of risk and return. The principle investors in CLOs are institutional investors: asset managers, pension funds, endowments, and sovereign wealth funds.

CLOs issue multiple debt tranches along with equity and use the issuance proceeds to obtain a diverse pool of syndicated bank loans. Interest and principal cash flows generated from the underlying collateral pool flow through the CLO and are distributed by a trustee to debt and equity investors. Each debt tranche carries a different risk and return profile based on credit quality, risk of loss, and priority to cash flow distributions. The equity tranche, also known as the first-loss tranche, absorbs initial losses and bears the highest risk; however, it also offers the potential for higher returns.

How does a CLO work?  

The process of purchasing and investing in a CLO begins with a bank that sells a pool of syndicated loans to a CLO manager. The manager gathers information on the underlying loans, splits the CLO into debt and equity tranches, and asks a rating agency to rate each tranche. The CLO manager then selects loans to put into the portfolio and sells the underlying pool of leveraged loans to investors.

The CLO tranches are structured in a waterfall, with the highest-ranking tranche getting paid first from the cash flows generated by the collateral, followed by the lower-ranking tranches in descending order. Institutional investors purchase various tranches according to the different risk/reward profiles of their clients.

How investors make money  

A quarterly waterfall calculation indicates where the cash will go, whether it will be reinvested into new loans during the reinvest period, and how it will be distributed to the tranche holders during repayment. Tranche holders will receive a series of payment streams called priority of payments based on their held tranche. A greater risk can mean an opportunity for greater return.

The trustee’s role  

Ratings agencies require an independent party to perform administration and compliance duties. A trustee maintains custody of the assets and distributes interest and principal payments, ensuring tranche holders receive the correct allocations.