By Joanne McEnteggart, Global Head of Debt, Capital Markets and Corporate
Collateralised loan obligations (CLOs) are a form of securitisation, providing a scalable path to investing in floating-rate loans while offering the relative security of an investment vehicle that has performed well across multiple credit cycles. With proper management and expertise, CLO finance can offer investors access to superior risk-adjusted returns.
In this article, we’ll explore what a CLO is, how it works, and what makes it a compelling investment vehicle.
CLOs explained in simple terms
CLOs are securitised financial products backed by diversified pools of debt. At their core, they are financial structures that pool together loans—often those with below-investment-grade ratings, such as first-lien corporate bank loans—and sell them in tranches to different investors.
What is securitisation?
Securitisation is the process of bundling groups of assets into a marketable financial product, called a security.
The loans within these debt pools, also known as leveraged loans, are often floating-rate and pay interest with rates tied to industry benchmarks like SOFR or LIBOR. While the loans that back a CLO carry more risk than traditional corporate bonds, they are also secured by assets, providing higher recovery rates in the event of default.
It can help to think of a CLO as a company that raises investor capital to purchase a portfolio of loans and then distributes interest income to investors based on the priority level of their tranche (explained in more detail below).
Common examples of CLOs
A typical CLO includes a pool of loans (usually 150-200 loans) from corporate borrowers across industries. These loans are senior secured, meaning they have the first claim on a company’s assets in the event of bankruptcy. CLOs often include loans from well-known Fortune 500 companies—large, well-established corporations with leveraged balance sheets.
Because they are senior secured, the leveraged loans within a CLO have historically shown higher recovery rates than unsecured bonds and are less likely to become distressed debt. According to a recent Nuveen report, CLO yields have increased by 41% over the last three years, solidifying their status as a consistently high-performing asset class within the broader loan market.
Who are common investors in the CLO market?
CLOs are designed to appeal to a broad range of institutional investors, largely due to the tranche structure, which offers tiered risk-return profiles. The highest-rated tranches, which offer lower levels of risk, are often bought by insurance companies, pension funds and banks. These institutional investors tend to prefer stable, predictable cash flow.
By contrast, hedge funds, private equity firms and high-net-worth individuals with a higher risk tolerance might invest in the equity tranche, which offers the potential for higher returns. For these equity investors, CLOs offer the potential for leveraged exposure to the underlying loans.
How are CLOs managed and structured?
CLOs are structured into CLO tranches—or “layers” of debt within the capital structure—with varying risk levels. Investors in the highest-rated tranches are the first to receive loan payments, while those in lower-rated tranches are last.
Investors in lower tiers face greater risk, but they also receive higher yields. At the bottom of the tranche structure is the equity tranche, which offers no fixed interest payments but captures residual returns from the CLO’s income after all other tranches have been paid. As the last to receive payment, the equity tranche also offers the potential for the highest returns, as it captures any leftover income after all other debt obligations have been met.
CLO managers play an active role within this ecosystem by continuously buying and selling loans within the portfolio, optimising returns, and maintaining regulatory compliance. Unlike other types of securities, CLOs are actively managed, allowing CLO managers to respond quickly to market changes to optimise performance.
What investors can gain from CLOs
The number of CLOs issued globally continues to grow, making them an attractive option for a wide range of institutional investors. In the United States alone, the CLO market is valued at nearly $1 trillion. CLOs offer several advantages to investors that make them an attractive opportunity:
- Higher yields: CLOs typically offer higher returns than traditional debt instruments
- Diversification: Because hundreds of loans from various industries are bundled together, investors can access a diversified portfolio to mitigate risk
- Lower default rates: Historically, CLOs have had lower default rates than other types of corporate debt, even during periods of economic uncertainty
- Inflation hedge: As floating-rate instruments, CLOs can act as a hedge against rising interest rates
A case study from one of our own clients, a global special situations investment firm headquartered in London, demonstrates the value of expert CLO management. The firm leveraged IQ-EQ’s support to successfully launch its first U.S. CLO and expand into the American market with best-in-class middle- and back-office infrastructure. Today, the firm’s CLO business continues to grow and its U.S. offerings are expanding.
Looking for help with managing your CLO? Get in touch with our team of experts today.
