Collateralized Loan Obligation (CLO) Structure, Benefits, and Risks

What Is a Collateralized Loan Obligation (CLO)?

A collateralized loan obligation (CLO) is a single security backed by a pool of debt. The process of pooling assets into a marketable security is called securitization. Collateralized loan obligations (CLO) are often backed by corporate loans with low credit ratings or loans taken out by private equity firms to conduct leveraged buyouts. A collateralized loan obligation is similar to a collateralized mortgage obligation (CMO), except that the underlying debt is of a different type and character—a company loan instead of a mortgage.

How Collateralized Loan Obligations (CLOs) Work

A CLO is a bundle of loans that are ranked below investment grade. They are usually first-lien bank loans to businesses that are initially sold to a CLO manager and consolidated into bundles of 150 to 250 loans. To fund the purchase of new debt, the CLO manager sells stakes in the CLO to outside investors in a structure called tranches.

With a CLO, the investor receives scheduled debt payments from the underlying loans, assuming most of the risk in the event that borrowers default. In exchange for taking on the default risk, the investor is offered greater diversity and the potential for higher-than-average returns. A default is when a borrower fails to make payments on a loan or mortgage for an extended period of time.

Each tranche is a piece of the CLO. The order of the tranches dictates who will be paid out first when the underlying loan payments are made. It also dictates the risk associated with each investment since investors who are paid last have a higher risk of default from the underlying loans. Investors who are paid out first have lower overall risk, but they receive smaller interest payments, as a result. Investors who are in later tranches may be paid last, but the interest payments are higher to compensate for the risk.

A CLO is an actively managed instrument: managers can—and do—buy and sell individual bank loans in the underlying collateral pool in an effort to score gains and minimize losses. In addition, most of a CLO's debt is backed by high-quality collateral, making liquidation less likely, and making it better equipped to withstand market volatility.

Types of CLO Tranches

There are two types of tranches: debt tranches and equity tranches. Debt tranches, also called mezzanine tranches, are treated just like bonds and have credit ratings and coupon payments. These debt tranches come first in terms of repayment, and there is also a pecking order within the debt tranches.

Equity tranches do not have credit ratings and are paid out after all debt tranches. Equity tranches are rarely paid a cash flow but do offer ownership in the CLO itself in the event of a sale. Because equity tranche investors usually face higher risks, they often receive higher returns than debt tranche investors.

CLO Structure

A CLO consists of several debt tranches, ranked according to the creditworthiness of the underlying loans. The lowest tier is the equity tranche, representing ownership of the underlying collateral.

As the CLO enters the repayment phase, investors in higher-ranked tranches are paid first, followed by lower tranches. Lower-ranked tranches have higher risk profiles, but also higher potential returns. In the lowest tier, the equity tranche, investors receive any additional cash flow after the debt investors are paid.

Equity tranche investors also have a degree of control over the CLO that is not available to debt investors. For example, they have options to refinance the underlying CLO loans or reset the reinvestment period.

CLO Process

Here's an over-simplied overview of how CLOs are created:

Step 1: Establish the Capital Structure. The first step to creating a CLO is establishing a capital structure, meaning the different levels of debt and equity underlying the security. A typical CLO has several debt tranches and an equity tranche, representing ownership of the underlying collateral.

Step 2: Seek Capital. The next step is to raise capital from investors, which is used to buy loans underlying the security. Each investor will contribute to a different loan tranche, with riskier tranches offering higher returns.

Step 3: Choose Tranches. As investors commit capital, they also have the opportunity to choose a tranche that meets their risk and return appetite.

Step 4: Purchase Loans. The CLO manager will use the capital from investors buy loans. The CLO manager can reinvest loan proceeds to improve the portfolio, either by buying additional collateral or selling poorly-performing loans. At this stage, an underwriter analyzes the loan pool and assesses the creditworthiness of the borrowers. The underwriter also determines the appropriate structure and size of the CLO transaction.

Step 5: Create Special Purpose Vehicle. Most often, a special purpose vehicle (SPV) is created to issue the CLO securities. The SPV is usually designed to protect the investors in case of default.

Step 6: Pay Investors. Ultimately, the CLO will begin repaying investors with a spread that has been pre-determined for each tranche at the time of closing. Afterward, holders of the equity tranche can call or refinance the loan tranches. Eventually, the CLO begins to deleverage. As the underlying loans are paid off, the CLO manager will repay the investors, starting with the most senior tranche. Any remaining proceeds will go to the equity tranche holders.

Step 7: Termination. The CLO transaction may terminate when all of the securities have been repaid or when the underlying loans have been paid off or sold. At this point, any special purpose vehicles are dissolved and any remaining assets are distributed to the investors.

Benefits of a CLO

There are a variety of benefits of a CLO, including but not limited to:

• Portfolio Diversification: CLOs can provide investors with exposure to a diversified pool of loans made to non-investment grade borrowers. This can help to reduce the risk of default associated with any individual loan or borrower.
• Higher Yields: CLOs typically offer higher yields than other fixed-income investments such as government bonds or investment-grade corporate bonds. This is because the loans underlying the CLOs are made to non-investment grade borrowers and are therefore considered to be riskier.
• Credit Enhancement: CLOs are structured with tranches with different levels of credit risk. This credit enhancement can provide additional protection to investors in the senior tranches against losses due to defaults in the underlying loans.
• Stronger Liquidity: CLO securities are typically more liquid than the underlying loans as they can be bought and sold in the secondary market. This can make it easier for investors to manage their portfolios and exit their positions when needed.
• Professionally Management: The collateral manager is responsible for managing the loan pool that backs the CLO securities, which can provide investors with access to professional management and expertise in the credit markets.

Risks to Consider

With those benefits in mind, there are also a number of downsides to CLOs. Those risks include but aren't limited to:

• Higher Credit Risk: CLOs are exposed to credit risk associated with the underlying loans. These loans are typically made to non-investment grade borrowers, which means they are more likely to default. A sudden increase in loan defaults could cause significant losses for investors.
• Residual Liquidity Risk: Although CLO securities are generally more liquid than the underlying loans, they are still subject to liquidity risk. During times of market stress, it may be difficult to find a buyer for CLO securities, which could make it challenging for investors to sell their holdings or exit their positions.
• Higher Interest Rate Risk: CLOs are typically structured as fixed-income securities with a set interest rate. If interest rates rise, the value of these securities may decline.
• Prepayment Risk: The underlying loans in CLOs can be prepaid, which means the borrower pays off the loan earlier than expected. This can negatively impact the returns of CLO investors, particularly if they were counting on a certain level of interest income over a longer period.
• Complexity: CLOs can be complex investment vehicles, with multiple tranches, different levels of credit risk, and varying payment structures. This complexity can make it difficult for investors to fully understand the risks involved and make informed investment decisions.

Risky Asset?

Some argue that a CLO isn't that risky. Research conducted by Guggenheim Investments, an asset management firm, found that from 1994 to 2013, CLOs experienced significantly lower default rates than corporate bonds. Only 0.03% of tranches defaulted from 1994 to 2019. Even so, they are sophisticated investments, and typically only large institutional investors purchase tranches in a CLO.

In other words, companies of scale, such as insurance companies, quickly purchase senior-level debt tranches to ensure low risk and steady cash flow. Mutual funds and ETFs normally purchase junior-level debt tranches with higher risk and higher interest payments. If an individual investor invests in a mutual fund with junior debt tranches, that investor takes on the proportional risk of default.

The Bottom Line

A CLO, or collateralized loan obligation, is a debt security backed by a pool of debt. Investors can choose one of several debt tranches to put their money into, with higher-risk tranches providing higher returns. Although yields may be higher than average, investors also assume the risk of borrower defaults.