What Is a Collateralized Loan Obligation (CLO)?

There are a wide range of different investment options out there, each varying considerably in terms of returns and risk.

One investment that many investors may not be familiar with is collateralized loan obligations, also known as CLOs. CLOs are a complex investment and require careful consideration before investing in them. In this article, we’ll look at what CLOs are, how to invest in them, and risks to consider before doing so.

CLOs are securities that are backed by a pool of leveraged loans. You can think of them as repackaged loans that are sold to investors.¹

CLOs typically issue multiple layers or “tranches” of debt instruments, as well as a residual equity tranche.² These tranches have different levels of risk, potential return, and payout priority.

The tranches in a CLO are:³

1. AAA Tranche
2. AA Tranche
3. A Tranche
4. BBB Tranche
5. BB Tranche
6. Equity Tranche

Tranches increase in risk and potential return profile in this order. Payout priority is also in this order once the tranche enters the repayment phase, with AAA receiving payment first.

Equity tranches rarely receive payment, but their investors partially own the CLO itself. Therefore, they have some level of control over the CLO that the debt tranches (all the other tranches) do not.

You can choose which tranche you’d like to invest in based on your risk tolerance and desired potential returns.

CLOs are actively managed by investment managers, meaning they may buy or sell loans within each tranche to strive for more potential gains and minimize risk.

Here is a brief overview of how CLOs are created:⁴

1.  The manager outlines the planned CLO’s capital structure, including the tranches
2.  The manager raises capital from interested investors
3.  Investors select and invest in their desired tranches
4.  The manager uses investor funds to purchase loans according to the capital structure
5.  The manager actively managed the CLO, buying and selling loans if needed to maintain risk and potential return profile
6.  The manager pays out interest in order based on tranches

CLOs could offer investors several benefits, these include:⁵

1. Over-collateralization
   The higher-ranking tranches in a CLO are over-collateralized. This means that even if some of the loans default, the high-ranking tranches are unlikely to be affected.


2. Less impact from fluctuating interest rates
   The underlying loans of a CLO are floating-rate loans. This means that the duration of the loans is shorter, which means that CLOs may be less subject to fluctuating interest rates.


3. Hedge against inflation
   CLOs can be used as a hedge against inflation because they consist of floating-rate loans.

There are some risks to consider before investing in CLOs. As with other securities, CLOs are subject to credit, liquidity, and market risks. It’s important for investors to understand how CLOs work, as well as the terms, conditions, and credit profile of the underlying loan collateral.⁶