What Are Collateralized Loan Obligations?

A Collateralized Loan Obligation (CLO) is a single security comprised of various corporate loans, generally used in institutional investor portfolios for stable cash flow. The loans are initially sold to a CLO manager, who then bundles multiple loans with a similar credit rating together and manages it as a single unit, actively trading to add or deplete the unit.

The investor is paid a yield from the underlying loans on a regular schedule. The risk the investor assumes is that the loan borrowers may default; however, CLOs provide risk management through diversification, and default risk is compensated with the potential for higher-than-average returns. In fact, because they hold a variety of loans, CLOs have proven to be less risky than corporate bonds of the same rating because they are diversified.1

To fund the purchase of new debt, a CLO manager will sell stakes in the CLO to outside investors through a structure called tranches, which is basically a risk stratification. Each tranche represents a level of risk linked to the investment, so investors designated to be paid first have the lowest risk but also the lowest interest payment. Investors allotted to later tranches are subject to greater risk but are compensated with higher interest rates. In this manner, payouts start at the top of the CLO capital structure (lowest risk lowest payout) and flow down to the bottom (highest risk, highest payout), which is often referred to as a waterfall distribution.

Within CLOs, there are two types of tranches: debt and equity. Debt tranches are paid out first. They are considered similar to bonds, with credit ratings and coupon payments, but follow a structured order in which debt tranches are paid out. Equity tranches represent ownership in the CLO and therefore receive a portion of proceeds when the security is sold.2

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1 Guggenheim Partners. Jan. 11, 2016. “The Benefits of Collateralized Loan Obligations.” https://www.guggenheimpartners.com/perspectives/portfoliostrategy/the-benefits-of-collateralized-loan-obligations. Accessed July 13, 2016.
2 Ibid.